With the advent of ESG investing, the case for differentiated analysis of companies using unconventional metrics appears to only grow stronger
A number of case studies have emerged in recent years that showcase how ESG data can reinforce the assessment of risks and bring to light material matters that can rapidly lead to corporate downfall.
In July 2018, major concerns centring on data privacy led to Facebook’s stock spiralling down after millions of Facebook users’ personal information was harvested without consent. The stock fell over -20% in one day and -40% for the rest of the year, losing more than $40bn in market capitalisation to the relative surprise of many investors banking on the firm’s rally of 20% year-to-date up until that point.
However, complaints about Facebook were not new, with widespread concerns about the company’s data management standards existing years before. Fundamental analysis does not capture the financial materiality of aspects such as this, however these factors were captured in ESG analysis from providers such as MSCI. There had been recurring red flags on privacy, data security and corporate governance, warning that a high proportion of operations that handle substantial quantities of sensitive personal information relative to peers, and that breaches and regulatory action were potential problems for the company.
In fact, MSCI downgraded Facebook’s ESG rating months before the scandal, from BBB to BB, thereby removing it from its SRI indexes in a rather timely manner.
Pacific Gas & Electric
The San Francisco-based natural gas and electricity company was one of the largest combined energy companies in the US, employing over 20,000 people and delivering energy services to over 16 million people in California. November 2018 saw the start of the deadliest wildfire season in California’s history, with the loss of over 100 lives and thousands of homes across the state. The fires were attributed to negligent operational practices on PG&E’s part.
Several months prior to the wildfires, MSCI’s ESG research highlighted several risks that were specific to the company, when assessed against other firms within the same industry. In particular, that the firm was subject to significant biodiversity and land use risks relative to peers, due to the concentration of its operations (84% are in California). The analysis also acknowledged the high risk of wildfires in this region, which amplifies the land use risk and MSCI pre-emptively downgraded the firm’s rating in September 2017 from BBB to BB, thereby preventing it’s presence in SRI indexes. PG&E filed for bankruptcy in January 2019 and in effect ESG research identified the risks to the firm’s stability long before they emerged in financial terms.
In November 2018, Nissan announced its chairman, and one of the auto industry’s most influential figures, had been arrested, accused of misappropriating company finances alongside other acts of misconduct.
Again, governance issues were flagged in ESG analysis of Nissan before November 2019. MSCI specifically flagged the lack of protection for minority shareholders’ interests and absence of an independent audit board or committee as an additional reason to be concerned about the board’s ability to oversee management. Most prophetically, MSCI noted that executive pay practices at Nissan raised significant concern, particularly in the areas of disclosure and alignment of management interests, concluding that the company’s disclosures and reporting practices warranted close attention from investors. For these reasons, Nissan was already assigned the lowest possible rating of CCC and excluded from SRI indexes.
Wirecard is a recent example of a corporate collapse. The German firm recently bankrupted following enormous auditing flaws and mismanagement of client assets. S&P excluded the company from its ESG index series shedding light on how the incorporation of governance factors in screening can identify companies with underlying financial mismanagement risks. Wirecard was granted a score of four out of 100 in the governance dimension of S&P’s financial materiality based on Corporate Sustainability Assessment, driven by: poor performance in the areas of privacy protection; risk and crisis management; and codes of business conduct.
Alongside fundamental analysis, ESG study has proven to capture risk factors that have not been fully priced. Aside from application to indexes, non-conventional factors and ESG overlays are becoming part of the norm when rating agencies formulate a view. Most recently Moody’s and S&P have started to incorporate ESG factors into their rating methodologies. The quality and breadth of non-financial data is improving rapidly enabling deeper insight and applied understanding into factors that will influence the future operating environment for companies – environmental change, regulatory policy and demographic shifts.
Recent major corporate downfalls have demonstrated that when there’s smoke, sometimes there’s fire and ESG factors can provide critical insights before it’s too late.