Summary
We analyze the forward-looking predictability of a consensus-based ESG score specifically as it relates to price volatility.
- We find that higher ESG scores are indicative of lower volatility over the following calendar year.
- This relationship is strongest for large cap stocks and is inverted for small companies.
ESG Overview
Investors’ focus on Environmental, Social and Governance (ESG) factors has increased dramatically in the last few years. Similarly, the number of companies now reporting ESG metrics has increased in a similar fashion and with it, the number of data firms providing this ESG information.
The issue, however, is that ESG scores are not standardized across providers and are, by nature, highly subjective depending on what the particular ESG data vendor deems important. This can (and does) result in ESG ratings that can be highly variable across company and time period making any kind of robust implementation difficult at best.
For this reason, we leverage the OWL Analytics database which uses a consensus approach to create their ESG scores that aggregates data from not only other ESG data providers but also hundreds of additional sources including NGOs, government databases, unions and activist groups.
Source: Owl Analytics
A Look at OWL Analytics by the Numbers
The data analyzed comprise roughly 2,500 US companies from the period 2015 – 2020. The Owl ESG score was evaluated for each company on the last day of each calendar year and compared to the realized monthly price volatility over the subsequent calendar year.
Large cap companies (defined as market cap of $10BN+) showed the highest concentration in the more favorable ESG deciles while Mid cap companies ($2Bn-$10Bn) were more evenly distributed and smaller companies were more likely to have lower ESG ratings.
This result is not surprising given the cost of implementing positive social, environmental or governance programs but it is interesting nonetheless to observe the reletave concentration of Large and Small companies in the More and Less favorable ESG deciles respectively:
The dataset consisted of 447 companies that were classified as LargeCap companies. As previously outlined, for each company, the ESG score was evaluated on December 31st and compared to that company’s volatility over the following calendar year.
The chart below shows the distribution of those volatility calculations over the subsequent year (25th percentile, median and 75th percentile) for each ESG decile.
It can readily be seen that as the ESG decile improves, so to does the median volatility over the following year as well as the distribution of volatility outcomes.
Not only do large cap companies with higher ESG scores typically demonstrate relatively lower volatility in the following year but they do so with a higher degree of confidence (as evidenced by the narrower distribution).
This is important as it conveys a degree of confidence around the improved volatility profile…i.e., the likelihood of an investor realizing the volatility benefit associated with higher ESG scores across different states of the world:
Looking at Midcap companies over this period, we see a more modest improvement in future volatility as ESG decile improves; although the improvement is notably more prominent among the 75th percentile volatility scores:
Perhaps most interestingly, is the reversal in this effect among small cap companies. As ESG scores improve, the smaller companies are more likely to demonstrate higher future volatility. Furthermore, we see an increase in future volatility even among the low-end of the distribution (the 25th percentile):
Noting the different scaling factors on the 3 previous charts, we superimpose the three below to more easily illustrate the marginal changes in volatility based on ESG decile across market caps:
Conclusion
As ESG solutions become more popular, it is both important and useful to understand the broad dynamics at play before implementing any kind of ESG score. While the robustness and intuitive appeal of consensus-based ESG scores are obvious, the evidence supporting their forward-looking predictive ability as it relates to volatility is equally appealing.
Importantly, the data reveals some interesting (although not entirely surprising) characteristics at play. Not surprisingly, larger companies tend to have higher ESG scores but also, ESG scores tend to be a better discriminator of future volatility among larger companies.
This effect is more muted among mid cap companies and slightly reversed among small companies. This is evidence of both an interesting area of further study as it relates to small cap companies as well a very useful framework for evaluating larger companies within a comprehensive ESG context.
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