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ESG Materiality in the European Equity Market

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ESG Materiality in the European Equity Market Università Cattolica del Sacro Cuore Facoltà di Scienze Bancarie, Finanziarie e Assicurative Master of Science in Banking and Finance ESG materiality in the European equity market Student Supervisor Pietro Marchesano Prof. Ettore Croci Università Cattolica del Sacro Cuore Facoltà di Scienze Bancarie, Finanziarie e Assicurative Master of Science in Banking and Finance ESG materiality in the European equity market Student Supervisor Pietro Marchesano Prof. Ettore Croci “Profit for a company is like oxygen for a person. If you do not have enough of it, you are out of the game. But if you think your life is about breathing, you are really missing something”. Peter Drucker Contents Acknowledgements .................................................................................................................................... 5 1. Introduction .......................................................................................................................................... 6 2. Literature Review and motivation ............................................................................................ 12 2.1 A framework to understand responsible finance and ESG analysis ................... 12 2.2 The increasing relevance of ESG screens and sustainable investing .................. 21 2.3 On the convenience of ESG integration .......................................................................... 26 2.4 First evidence on ESG materiality .................................................................................... 34 2.5 Hypotheses ................................................................................................................................ 40 3. Empirical analysis ........................................................................................................................... 43 3.1 Data and sample ...................................................................................................................... 43 3.2 Materiality (Immateriality) score construction .......................................................... 65 3.3 Portfolios formation .............................................................................................................. 73 3.4 Alphas estimation ................................................................................................................... 76 3.5 Results ......................................................................................................................................... 87 4. Conclusion ........................................................................................................................................ 108 Bibliography ............................................................................................................................................. 110 Acknowledgements I would like to express my deepest gratitude to all those who supported me during my studies and, specifically, while conducting this research. On the academic side, I immensely thank my supervisor, Prof. Croci: his promptness in replying to my emails and thoroughness in reviewing my drafts were pivotal to make me work effectively, considering my internship and the consequent time pressure. I also thank Prof. Newton, whose lectures at the Frankfurt School of Finance & Management introduced me to the fascinating concept of ESG materiality, and Prof. Del Giudice, Prof. Moslener and Prof. Lucius who advised me on the most relevant issues to be investigated in the domain of responsible finance. On the personal level, many other people deserve special thanks. I thank my parents for their presence and my siblings for being an infinite source of inspiration: Francesco for his achievements and vividness, Benedetta for her sharp but affectionate genuiness, Andrea for his gentleness, humor and loyal closeness. My grandma’s exemplary stamina also taught me a lot. I am then grateful to my uncle Marco – whose stories of successful entrepreneurs and managers helped me understand business was the right track for me – Elisabetta, and my kind and joyful cousins Enrica, Camilla and Giovanni. I finally thank my relatives from Apulia and Calabria for their unconditional love and our unforgettable vacations together. Last but not least, some much needed friends. I thank Alessandro and Matteo for growing up with me, the group in Canaro for reminding me my wonderful childhood and adolescence, Nicola, Sara, Laura, Caterina, Leonardo for their cheering company in the challenging years of Padova and HyunWoo, Joming, Valentine and Giancarlo for the light- hearted and enriching moments shared in Frankfurt. 1. Introduction Asset management companies use more and more ESG data to make financial decision. As of January 2018, $12.0tn and $13.6tn are invested taking into account sustainability criteria in the US and Europe (US SIF, Eurosif, 2018): 26% and 44% of the total assets under professional management in those markets. Not all ESG data are relevant from an investment standpoint. Eccles and Serafeim (2013) define ESG material issues as “the ones that have the greatest impact on the firm’s ability to create shareholders value”. The increasing importance of sustainability and the large amount of ESG information available make ESG materiality particularly topical. However, little evidence is provided on its contribution to the generation of positive abnormal returns. The Sustainability Accounting Standard Board (SASB), the body accredited to set sustainability accounting standards by the American National Standards Institute, recently created the Materiality Map®. The basic idea behind this map is that the material nature of a certain sustainability issue depends on the industry a company belongs to. The purpose of my study is to investigate the relation between financial and both material and immaterial sustainability performance. I follow the methodology outlined by Khan et al. (2015), the only scholars exploiting SASB’s powerful classification of ESG issues and I complement their analysis focusing on the European – rather than US – market and using a different sustainability database. This is very relevant. On one hand, many studies demonstrate that the impact of ESG sustainability over a company’s financial performance may vary a lot, depending on the market where it is tested – see, for instance, Auer and Schuhmacher (2016); on the other hand, Chatterji et al. (2015) document that extra-financial rating agencies are 6 characterized by a surprising lack of agreement. The first point suggests that the evidence emerged in the US may not apply in Europe. The second highlights that, as ESG ratings tend to diverge, results based on KLD may be different from the ones based on Asset4. The ultimate importance of this study lies in the possibility to be useful to a large spectrum of actors, notably companies and investors. With reference to the former, it intends to define whether it is financially worth it to distinguish between material and immaterial issues. Focusing on the latter, it may help investors include ESG analysis in their investment decisions with a greater awareness on the financial implications of the sustainability criteria used. In this thesis, I define a way to fit Thomson Reuters Asset4’s datatypes into the framework provided by the Materiality Map® and I standardize the former to be able to compute a yearly score for each company’s material and immaterial performance, consistently with Khan et al. (2015). I regress the yearly changes into the material (immaterial) performance score onto changes into proxies for size, growth opportunities, leverage and profitability. The resulting residuals represent the unexplained portion of the score’s change. The higher such portion is, the greater is the company’s unpredicted effort in increasing its material (immaterial) sustainability performance. Henceforth, the firms with the highest (lowest) residuals are considered as material or immaterial sustainability outperformers (underperformers) and allocated to the most (least) materially or immaterially sustainability portfolios. Equal- and value-weighted portfolios are formed according to different cutoffs of the obtained residuals (deciles, quintiles, quartiles and tertiles). I test whether portfolios including companies with high ESG material and immaterial performance beat portfolios whose constituents fall behind on these issues (Hypothesis 1 and 2) and whether portfolios including companies that rationalize their investments in 7 only the most ESG material issue, neglecting the immaterial ones, beat portfolios of firms with a poor performance on material issues and concurrently good performance on immaterial ones (Hypothesis 3). Given the evidence emerged in the US market I expect that: companies with a high performance on material sustainability issues (HM) significantly outperform firms that do not properly cope with these issues (LM); companies with a high performance on immaterial sustainability issues (HI) do not to significantly outperform firms with low performance on them (LI); and firms with a good performance on material issues and poor performance on immaterial ones (HM&LI) deliver the highest abnormal returns. To test the three hypotheses, I estimate each portfolio’s abnormal returns through the Carhart four-factor model, over a ten-year time horizon: from the beginning of July 2008 to the end of June 2018. To have a more precise idea on the differential alpha associated with being included in HM rather than LM portfolios
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