Building a Portfolio

When “Externalities” Aren’t External: Poor ESG Exposure Leads to Increased Risk

In 2015, Newsweek highlighted the effects of the garment industry on the south Indian city of Tirupur. On the one hand, the industry earns billions of dollars each year and employs hundreds of thousands of people. But the chemical pollution it generates has also devastated the environment—and the local community’s health along with it.

Many companies write off these kinds of environmental, societal, and corporate governance (ESG) factors as “externalities”—incidental effects on unrelated third parties. While some will balk at an absence of corporate altruism, disregard for such externalities can have financial consequences, too. Evidence suggests that the long-term performance of these companies entails more risk than that of companies with high ESG scores.

According to a study by AQR Capital Management, the decrease in risk for ESG investments—around 1%—may seem modest at first glance. However, it’s anything but. Instead, the full impact of this lowered risk may be more likely to play out over the long term. Since governance risks like scandal or earnings misstatements may take many years to materialize, as the report points out, they’re harder to forecast accurately. Traditional risk models are based on historical data and tend to work best over short time frames.

The study found that social and governance externalities tend to make a stock riskier than environmental concerns, but it speculated that this may be because environmental risks take longer to develop than the time span used in their statistical analysis.

However, firms with poor ESG scores (no matter the sector) may be riskier because such behaviors can result in falls in share price when that behavior catches up to them. A company with high emissions, for example, might be subject to a carbon tax down the road. A company that mistreats or neglects its workers could see a huge fine, such as the $4.5 billion fine BP paid in 2012 after failing to ensure worker safety.

Similarly, outside research cited in the AQR report suggests that measures of some externalities, such as better corporate governance, correlate with higher returns. For example, a National Bureau of Economic Research study cited by AQR found that organizations with governance issues like the planned reduction of shareholder rights (e.g., poison pills) tend to earn lower average returns than those with high governance rankings. For example, in 2015 governance issues at BNP Paribas resulted in violations of economic sanctions, which led to the forfeiture of almost $9 billion in assets and a fine of $140 million.

For investors designing portfolios using ESG factors, it’s good to know that it’s possible not only to achieve market rate returns but also to mitigate risk. Not to mention the reason that so many investors are attracted to impact investing in the first place: making a sustainable, positive contribution.