Huge bank climate risks: 2022 climate risk stress test by the European Central Bank as of July 2022: “The share of interest income related to the 22 most GHG-emitting industries amounts to more than 60% of total non-financial corporate interest income on average for the banks in the sample … the two physical risk scenarios (flood risk and drought and heat risk), the combined credit and market risk losses for the 41 banks providing projections would amount to around €70 billion. For a number of reasons this estimate significantly understates the actual risk” (p. 5). … many banks are still at an early stage in terms of factoring climate risk into their credit risk models (p. 6) ….at least some of the banks were able to address the challenges in a satisfactory manner, suggesting that it is possible for the industry to raise the bar across all of the areas assessed” (p. 7).
Worsening ESG Investing?
(ESG) model problems: Building Knowledge by Mapping Model Uncertainty in Six Studies of Social and Financial Performane by Luca Berchicci and Andrew a. King as of April 15th, 2022 (#15): “Any single empirical study provides a weak basis for inference. As a result, scholars advocate repeated analysis of important issues … six important studies of the link between corporate social and financial performance have been published in this journal, but their conflicting results have defied integration. …. a new approach to empirical research allows their reconciliation: all six suggest that across firms, social and financial performance are correlated but that improvements in social performance seldom precede increased financial performance” (p. 1).
Governance literature analysis: The Economics of Corporate Governance by Mathieu Pellerin of Dimensional Fund Advisors as of July 27th, 2022 (#59): “This paper surveys the academic literature on the governance of for-profit, publicly traded corporations. … we discuss how shareholder value maximization relates to alternative doctrines such as stakeholder capitalism, and why the alternatives are likely to fall short of their promises. We then review the role of corporate governance in addressing potential conflicts of interests between shareholders and their agents: directors and executives. The paper then turns to the empirical literature, which finds that electing independent and qualified boards, allowing takeover markets to operate freely, and aligning executive compensation with shareholder interests all have a positive effect on shareholder value” (abstract).
Diverging E ratings? Disaggregating confusion? The EU Taxonomy and its relation to ESG rating by Maurice Dumrose, Sebastian Rink, and Julia Eckert as of August 2022: “ESG firm-level ratings tend to differ across ESG data providers … We argue that the EU Taxonomy can support the reduction of this divergence. … we show that environmental ratings from three out of four ESG data providers are significantly related to the EU Taxonomy. However, our results suggest that the potential for reducing measurement divergence has not yet fully materialised.” (abstract).
Thematic ESG Investing? Indices Insights Summer Summaries – From ESG to SDG integration, then to assessing investment implications by Robeco as of July22nd, 2022: “Passive investors can pursue SDG integration or carbon footprint reduction without compromising their financial objectives (p. 1). … more than half of the tobacco producers that are excluded from the portfolios of large asset owners receive an average ESG rating or are even considered ESG leaders by MSCI. By the same token, more than 50% of these companies are assessed as having neutral or even low ESG risk according to Sustainalytics (p. 2) … about 25% of the investee companies in our sample of popular third-party thematic impact funds with a focus on clean energy are considered to have high ESG risk (p. 3). My Comment: The results are not that that surprising since most ESG-ratings measure the risks for the companies. And environmental risks are typically high for companies producing energy. Also, ESG typically measures only how companies are operating, not what they are doing. I use SDG-alignment for the “what” questions. And that is why I use only thematic ETFs with the highest E, S and G rating-averages for their components and require high individual minimum E, S and G-Ratings for my direct equity SDG portfolios since 2017. My comment: See Drittes SDG ETF-Portfolio: Konform mit Art. 9 SFDR – Responsible Investment Research Blog (prof-soehnholz.com). I recently developed 2 more Article 9 portfolios (details at request).
Worsening ESG investors: 5 Takeaways on ESG Investing from 1,500 Institutional Equity Strategies by Julie Moret of Northern Trust in Integrating ESG strategies into institutional portfolios by Clear Path Analysis as of July 2022: “… we analyzed from 2017 to mid-2021 more than 1,500 equity strategies of 75 institutional investors … Across most of the client types in the analysis, portfolio ESG scores lagged relative to their broad benchmarks … we found, that portfolios scored higher than their benchmarks on corporate governance … monotonic downward trend with the environmental pillar … the environmental pillar not only captures carbon reduction. It also captures elements of waste, water management, natural resource use, and financing of environmental opportunities, where we found that portfolios generally scored lower. We think this is because of the focus on cutting carbon emissions and decarbonization … when investors combine ESG investment managers, our analysis shows that they can unintentionally dilute away compensated risks and intended ESG exposures because of offsetting positions between the managers” (p. 9-12). My comment: I use separate and rather high minimum threshholds for E, S and G Ratings separately to avoid these problems, see ESG first or „Responsible investments: No excuses left“ – Responsible Investment Research Blog (prof-soehnholz.com)
Voting, Engagement and Divestments: Worsening ESG?
Engagement pays off: Private Shareholder Engagements on Material ESG Issues by Rob Bauer, Jeroen Derwall, and Colin Tissen as of July 29th, 2022 (#382): “We study a unique database of 12,727 private shareholder engagements on ESG issues targeted at 2,465 publicly listed firms worldwide from 2007 to 2020. … Using the materiality frameworks of SASB and MSCI ESG … We find that firms targeted by successful material engagements significantly outperform peers by 2.5% over the 14 months following an engagement (p. 20). … Material social and governance engagements most consistently show significant associations with future performance in terms of higher profitability and lower expense ratios. … Next to financial performance, our evidence indicates that engagements are, on average, accompanied by an improved ESG performance of target firms. Importantly, environmental engagements are associated with a decrease in CO2e intensity and an increase in the MSCI environmental score. However, we do not observe a significant decrease in the total level of CO2e emissions” (p. 21). My comment: I only invest in the most sustainable companies anyhow and I think that the potential scope of engagement is very limited, see Divestments bewirken mehr als Stimmrechtsausübungen oder Engagement | SpringerLink, but nevertheless started an engagement myself.
More engagement potential: Bucking the Trend: Why do IPOs Choose Controversial Governance Structures and Why Do Investors Let Them by Laura Field and Michelle Lowry as of August 5th, 2022 (#617): ““Within the latter years of our sample period, over 70% of IPO firms have classified boards and over 20% have dual class share structures; in comparison, the analogous percentages among mature firms are only 30% and 7%. … engaged mutual funds are equally likely to support directors of firms with classified boards and annual boards. … We also find that newly public firms are subject to less external pressure, for example in the form of shareholder proposals, compared to more mature firms that tend to be larger. Within the first five years after the IPO, less than 4% of firms receive a shareholder proposal in a year, compared to 17% of mature firms” (p. 32/33).
Costly exclusions? The expected returns of ESG excluded stocks. The case of exclusions from Norway’s Oil Fund by Erika Berle, Wanwei (Angela) He and Bernt Arne Ødegaard as of May 3rd, 2022 (#190): “We used the exclusions by the Norwegian Government Pension Fund Global, the world’s largest SWF, to identify a set of firms with a low ESG ranking. … The portfolios of these stocks have statistically significant positive excess returns (alpha) as high as 5% in annual terms. … the stocks excluded for reasons of conduct have higher returns than product-based exclusions. Also, the alphas are even higher for the portfolio of only US-listed stocks. … We argued that the sheer magnitude of the return difference (5%) rules out short-term price pressure as a complete explanation and refers to the estimates of the one-time shock to stock prices at the time of exclusion announcement (1.5% or lower). We are left to conclude that our results indicate that low quality ESG firms have a return premium” (p. 22). My comment: Let’s see how long there are enough solvent buyers for excluded stocks.
Critical opinion: The problem lies in the net – How finance can contribute to making the world reach its greenhouse gas net-zero target by Finance Watch as of June 30th, 2022: “To achieve net-zero in the economy, non-financial companies must become carbon neutral … several areas are emerging as critical to the debate: Measuring absolute GHG emissions, not GHG intensity. … Including scope 3 emissions in emissions disclosures. … Excluding carbon offsets. … Excluding avoided emissions. … Within the financial sector … While divestment from fossil fuel assets is possible and can exert a useful pressure, that is not the case for the rest of the economy. … In today’s portfolio management world, it is impossible to build very large carbon neutral investment portfolios. … … Equity owners can influence non-financial companies through shareholder engagement, while lenders, insurers and private investors can influence companies by imposing conditions and covenants. Shareholder engagements by investor coalitions … have led to an impressive 69% of the world’s highest emitters making net-zero commitments. But only 17% of those emitters have so far made a credible decarbonisation strategy. … we propose a three-pronged approach in which no financial services should be marketed as ‘ESG’, ‘climate-oriented’ or ‘net-zero’ unless they fall into one of three categories: they relate to activities that are compliant with the EU Taxonomy, they are accompanied by a robust engagement plan, or they feature suitable climate covenants” (p. 4-6).
Other interesting investment research
Fund drawdowns matter: Maximum Drawdown as Predictor of Mutual Fund Performance and Flows by Timothy Riley and Qing Yan as of July 18th, 2022 (#212): “We find that a fund’s past maximum drawdown has unique predictive power with respect to subsequent performance and that investors give considerable weight to a fund’s past maximum drawdown when allocating capital. Among funds with relatively strong past performance, those with relatively low past MDD outperform those with relatively high past MDD by 2.40% per year (t-stat = 2.87). Consequently, it is not surprising that there is a large negative relation between fund flows and MDD” (p. 24). My comment: I use maximum drawdown since many years successfully for equity risk analysis
Bad VC information analysis? Predictably Bad Investments: Evidence from venture capitalists by Diag Davenport as of July 28th, 2022 (#9329): “I combine a novel dataset of over 16,000 startups (representing over $9 billion in investments) with machine learning methods to evaluate the decisions of early-stage investors. … By comparing investor choices to an algorithm’s predictions, I show that up to half of the investments were predictably bad—based on information known at the time of investment, the predicted return of the investment was less than readily available outside options. The cost of these poor investments is 1,000 basis points, totaling over $900 million in my data. I provide suggestive evidence that over-reliance on the founders’ background is one mechanism underlying these choices. Together the results suggest that high stakes and firm sophistication are not sufficient for efficient use of information in capital allocation decisions“ (abstract).