ESG Controversies and Their Impact on Performance

Abstract

This article introduces an aggregated controversy metric—derived from environmental, social, and governance (ESG) data—that targets specific issues companies face in the environmental, social, or governance fields. By building portfolios based on this controversy measure, the study shows that in Europe and the US, stocks that undergo severe controversies significantly underperform both their benchmarks and other portfolios consisting of stocks with low controversy or no controversy at all. The main reason for this result is that, in both cases, markets tend to react strongly to changes in controversy levels, penalizing stocks that experience ESG downgrades. These results make a clear case for the potential benefits of excluding stocks with high-controversy levels from investment universes. However, these findings are not confirmed for the Asia-Pacific region, where the portfolios consisting of highly controversial stocks outperform their benchmarks, although the number of such portfolios is lower compared to the number in Europe and the US.

TOPICS: Portfolio theory, portfolio construction, ESG investing

Key Findings

• • High levels of ESG controversies have a significant impact on stock returns for US and European stocks.

• • Europe displays a clear surprise effect, where unexpected severe downgrades in the controversy levels are usually associated with persistent negative excess returns up to 12 months after the downgrading. For the US, we do not notice a surprise effect, but progressive downgrades are penalized by the market (a deteriorating effect).

• • For Asia-Pacific stocks, there is little evidence so far that stock markets react negatively to ESG controversies and rating downgrades.