Lars G. Hassel The Economic Value of ESG/SRI EAPSPI Conference on Sustainable Investments October 24, 2014 Hotel Kristina.

Lars G. HasselThe Economic Value of ESG/SRI

EAPSPI Conference on Sustainable Investments

October 24, 2014

Hotel Kristina

Outline for an Academic Approach• Sustainable and Responsible Investment strategies• SRI value creation in financial markets• ESG metrics in research papers• Errors in investors’ expectations and learning

– The alpha puzzle and market efficiency

– Learning and Disappearing Association between Governance and Returns (Bebchuk et al., JFE 2013)

– Stakeholder Relations and Stock Returns: On Errors in Investors’ Expectations and Learning (Borgers et al., JEF 2013)

• Evidence from academic studies on portfolio analysis, event studies around earnings announcements, analysis of errors in analysts’ forecasts, and firm value studies

• Conclusions with implications

Sustainable and Responsible Investment Strategies

SRI in Europe - Eurosif

SRI – by Country

ESG Value Creation in Financial Markets

• How does market price ESG ? Extra-financial value

• The market overlooks the benefits of ESG?

• ESG at firm level associated with productivity, efficiency, and hence, cash flow

• When benefits to ESG materialize, SRI investor enjoys positive earnings “surprise”?

Alpha ESG drives future cash flows

Impact on company valuation

Errors in consensus

expectations

ESG Metrics - dimensions

Thomson Reuters (ASSET4)

Global Engagement Services

MSCI ESG Research (KLD Research and Analytics)

Semenova and Hassel: On the Validity of Environmental Performance Metrics, JBE 2014

ESG and Stock Return – Alpha Puzzle

Institutions often justify their responsible practices using the argument that ESG factors generate positive investment returns (alpha).

Investors (and companies) that exploit this market inefficiency will benefit from an early mover advantage that can last decades before risk-return equilibrium is established (2012)

ESG and Stock Return – Alpha Puzzle

Abnormal return!Derwall et al (FAJ, 2005): The high-ranked portfolio based on Innovest eco-efficiency ratings provided substantially higher average returns than its low-ranked counterpart over the 1995-2003 period.

ESG and Stock Return – Positive Alpha

Abnormal Return - Mispricing? Factors: market, small-large, value-growth, momentum

Stock market anomalies

• Classical EMT suggests that trading strategy based on public information cannot produce abnormal returns (Fama, 1970).

• Adaptive EMT suggests that the ability of trading strategy to generate abnormal returns will disappear over time (Daniel and Titman, 1999).

• Errors in expectations and Learning – evidence from SRI studies (Bebchuck and Borgers studies, 2013)

Errors in Investors’ Expectations and Learning

Intangible nature of ESG Mispriced information eventually disappears when

investors learn about the anomaly Increased integration of ESG factors Media and research attention More shareholder proposals on ESG issues

Positive risk-adjusted returns on portfolios of high-ranked ESG stocks will disappear

ESG earnings surprises will disappear Positive association with firm value (Tobin’s Q) will

persist

Governance and stock returns

• Learning and disappearing association between governance and returns by Bebchuk, Cohen, Wang (JFE, 2013)

• Investor Responsibility Research Center (IRRC) Corporate Governance data on S&P 500– Democracy firms (Good G) and Dictatorship forms (Bad G) based on

• G-Index (24 IRRC provisions; such as voting rights, CEO protection, tactics for delaying hostile bidders, other takeover defences)

• E-Index (limited to 6 IRRC provisions)

– High G-Index and E-Index (protection) = poor Governance

– Periods: 1990-2008; 1990-1999 and 2000-2008

Good Governance Effect• The disappearance of the governance-return correlation was associated

with an increase in the attention to governance by a wide range of market participants;

• Until the beginning of the 2000s, stock market reactions to earning announcements reflected the market’s being more positively surprised by the earning announcements of good-governance firms than by those of poor-governance firms;

• Stock analysts were also more positively surprised by the earning announcements of good-governance firms than by those of poor-governance firms until the beginning of the 2000s but not afterwards;

• While the G-Index and E-Index could no longer generate abnormal returns in the 2000s, their negative association with Tobin’s Q and operating performance persisted (good-governance firms higher market value).

Attention paid to G by media and institutional investors increased from 2000

Structural break in abnormal G returns occurred in November 2000Critical learning point occurred in October 2001

Governance indices and abnormal stock returns

Abnormal returns fade out over time

Governance indices and operating performance and Tobin’s Q

Association between governance indices and operating performance and Q persist during both 1990-2001 and 2002-2008

Environmental and Social information and stock returns

• Stakeholder relations and stock returns: On errors in investors’ expectations and learning (Borgers et al, JEF 2013)

• Stakeholder-relations index, SI– (KLD ES ratings: emissions and pollution prevention,

environmental management systems, community involvement, diversity, employee relations, product quality, human rights)

• High SI = high ES ratings• U.S large cap 1000-3000 firms (1992-2009; 1992-2004

and 2004-2009)

ES mispricing is eliminated

• Provide evidence that the Stakeholder-relations Index (SI) explained errors in investors' expectations about firms' future earnings 1992–2004. – SI was positively associated with long-term risk-adjusted

returns, – Earnings announcement returns, and – Errors in analysts' earnings forecasts over the period

• When attention for stakeholder issues became more widespread, these relationships diminished considerably.

• The results are consistent with the idea that increased investor attention for stakeholder issues eliminates mispricing.

Number of shareholder proposals

CSR in the news

Number of occurrences for CSR in the newspapers, including the Wall Street Journal, the Financial Times (Capelle-Blancard and Petit, 2011)

Learning effect: time variation in abnormal returns top-minus-bottom ES ranked portfolios

Critical learning point occurred in April 2004

ES and risk-adjusted returns

ES and earnings announcement returns

Subsample 2: April 2004 – December 20091992-2004: higher abnormal returns around earnings announcements2004-2009: earnings surprises disappear

Errors in analysts’ forecasts Error: actual EPS minus consensus analyst long-terms forecast from I/B/E/S

Positive Errors 1992-2004Zero Errors 2004-2009

ES and Operating Income

Performance of shunned-stocks and high employee relations portfolios 1992-2008 (Derwall et al., 2011)

Shunned stocks: KLD Controversials (tobacco, alcohol, gaming, nuclear, firearms)Values-driven v. profit-seeking SRI

Performance of controversial stocks

Controversial stocks outperform!

Study Region and Period

Tobac. Alc. Game Weap. Nuke Biotech Adult Alpha

Hong and Kacperzyk (2009)U.S.

1926-2006 X X X X Positive

Kempf and Osthoff (2007)U.S.

1991-2004 X X X X X Positive(non-significant)

Statman and Glushkov (2009)U.S.

1992-2007 X X X X X Positive(non-significant)

Salaber (2007)Europe

1975-2006 X X X Positive

Fabozzi et al. (2009)21 countries1970-2007 X X X X X X X Positive

Visaltanachoti et al. (2009)China

1975-2006 X X X Positive

Conclusions and Implications• Mispriced ESG information has generated in the past superior

risk-adjusted returns in the short run• Increased attention for ESG issues has eliminated errors in

investors expectations in the long run (learning effect) – Correlation between G and abnormal returns disappears from 2000– Correlation between ES and abnormal returns disappears from

2004• Public ESG information used by researchers is not able to

provide a basis for profitable trading strategy.• Positive association with operating performance and market

value persists in the long run • ESG becomes more significant in the market and to be taken

into account by investors

Doing well while doing good!