Clarity AI: ESG Controversies Led to a 2% to 5% Stock Underperformance after Six Months

Higher severity ESG-related incidents led to larger divergence in stock performance compared to lower severity cases; the largest deltas were associated with controversies related to negative environmental impact and to mismanagement of a company’s products and services.

ESG-related controversial incidents often receive significant attention from the media but the link between these controversies and actual stock performance isn’t always clear.

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“Understanding the risks associated with corporate controversies and taking appropriate actions when controversies do occur can help investors build stronger-performing portfolios and help companies react appropriately to minimise market value loss and maintain investor confidence.”

Analysis by Clarity AI, the global sustainability technology platform, tests the hypothesis that involvement in ESG Controversies is a valid predictor of corporate medium-term value loss.

Investors can perceive controversial incidents as a potential sign of poor management or a lack of ethics, which can erode investor confidence and make them less willing to invest in the company’s stock. The legal and regulatory consequences of such incidents can also be expensive and time-consuming to resolve, further damaging the company’s reputation and market value. Finally, such incidents can disrupt a company’s operations, leading to a decline in productivity and profitability, which can negatively impact its market value.

The analysis indicates that controversial actions linked to ESG can have a significant negative effect on a company’s value compared to peers, resulting in a delta in valuation ranging from -2% for less severe controversies to -5% for the most severe controversies after a period of six months.

The analysis covered over 10,000 controversial incidents for more than 1,500 corporations spanning over a four year period. All incidents were classified into one of three different severity groups, namely: Low, Medium, and High. This classification has been done according to the increase in the ESG-derived risks for the company as estimated by Clarity AI’s models, which take into consideration the magnitude of the issue, its impact on stakeholders, and the management by the company. The magnitude of the impact was further broken down considering the type of incident and the industry to which the company belongs.

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For the incident type, the research analysed the effect of controversies around four main topics: negative environmental impact, corporate governance issues, market dominance abuse and company mismanagement of its products and services. The largest deltas in stock performance were found for High severity cases and the topics of products and services mismanagement (-11.8% market value divergence on average) and negative environmental impact (-8.9% market value divergence on average). In general, higher severity incidents led to larger deltas in company value when compared to lower severity cases.

The analysis also tested whether the impact of controversies on market value can be greater if the controversy is related to a topic that is material to the industry the company operates in – for example the environmental topic for the mining industry or corporate governance topics for the consumer finance industry.

Results confirm that the effects derived from a company’s involvement in such activities exceeds that of the average of all similar incidents for all companies. The difference is significant, being as large as twice as much for environmental cases and almost three times as much for bad corporate governance controversies.

The analysis confirms that Controversy scores based on Natural Language Processing, like the ones developed by Clarity AI, can be an effective tool for identifying and tracking the evolution of these incidents. ESG frameworks must include these metrics to measure a company’s controversial behavior as an additional outside-in measurement of the ESG risk that corporations are exposed to.

Borja Cadenato, Director of Product at Clarity AI, said, “Understanding the risks associated with corporate controversies and taking appropriate actions when controversies do occur can help investors build stronger-performing portfolios and help companies react appropriately to minimise market value loss and maintain investor confidence.”

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