The world is full of ESG ratings promoting the benefits of a stellar corporate performance on environmental, social and governance factors. But what of the downsides? New research suggests ESG-related incidents can reduce stock performance in the future, though investors appear to be struggling with how to price it in.

The research looked at 80,000 ESG incidents at 2,700 US companies to find out what happened to stock performance after the bad news. It may come as no surprise to learn that stock performance fell over the long term and when new ESG incidents hit the news. But what emerged as a surprise is that many investors fail to price in bad news, leading to overpriced stocks in the short term.

According to the author, Simon Glossner at Darden Business School, University of Virginia, his findings “suggest that stock markets underreact to poor ESG practices. High ESG incident rates negatively impact long-term value, but stock markets do not fully impound this, which leads to abnormal returns when lower earnings or new incidents materialise.”

ESG incidents linked to underperformance

Glossner’s research finds that ESG incidents in the past predict future incidents and lower profits. Secondly, he finds a portfolio of US stocks with “high ESG incident rates” is associated with a performance below the market average of -3.5%. These results were replicated when Glossner looked at European companies, finding underperformance of -2.5%.

The study shows that the manufacturing sector experiences most bad news, followed by finance and mining.

But analysts appear to be missing bad news. “Analysts forecast errors point toward underreaction,” writes Glossner, suggesting “analysts overestimate the earnings of firms with high incident rates”.

One reason analysts fail to spot ESG issues looming is that they are “inattentive” to historic misdemeanours. However, there may be another issue: Glossner points out that ratings used by analysts can disagree significantly when portraying the performance of a company.

While there is much to learn here for investors, Glossner says there are lessons for corporates too, notably the “long-term cost of poor ESG practices”.

Ignoring bad ESG news can have other outcomes. Analysts failing to assimilate bad news leads to overpriced stocks which can, in turn, lead to complacent corporate leaders.

Executive pay incentives

The Covid-19 pandemic has caused investors and boards to place a renewed focus on ESG factors, though it was already a major issue as concerns about the climate crisis heightened.

Recent research by ISS, the investor advisory group, found the use of ESG metrics in executive pay incentives has doubled.

France has the the highest rate of adoption, with 51% of companies using at least one ESG metric in their remuneration plans, followed closely by Spain with 48%. The UK ranks eighth with almost a third, 32.8%, with the US struggling on 7.8%, though that figure may represent a large number of companies.

According to Casey Lea, an ESG expert at ISS, environmental and social measures are now a “critical issue”.

“This rapid increase in adoption means investors must be mindful of not just who is adopting these incentives but also what type of metrics are being used, how important they are in driving executive pay, and the performance period on which they are measured,” he says.

Elsewhere, the growth of ESG investing has been marked. Morningstar, an investment research group, says $51.1bn of net new money found its way into ESG funds during 2020, up on the $21bn in 2019.

ESG is a major issue for corporate leadership and investors alike. This new research suggests boardroom should heed the warnings provided by news and mend their ways. Investors will eventually get wise.