Directors have a duty to uphold and enhance the reputation of their firms to ensure their success and drive growth. This reputation is inextricably linked with actions and values on environmental, social, and governance (ESG) issues, which are increasingly important to consumers, investors and regulators.
While the importance of ESG and reputation is clear, how to quantify this often-intangible asset and the value that it delivers is less so. There are numerous firms that compile ESG scores and present them in a similar fashion to credit risk scores. Quantification is appealing but, unlike credit risk, there's no observable event (such as a default on payment) against which to benchmark an ESG score. Due to the lack of regulation and various data issues, ESG scores vary significantly between ratings companies.
Rather than quantifying reputation or ESG scores, we show that a simple empirical technique, and real-world events that result in reputational damage, can be used to quantify the value loss that results from reputation damage.
A firm’s reputation can be defined as the aggregation of its stakeholders’ evaluation of past behaviour. Past behaviour is used to inform expectations regarding current and future behaviour in the presence of imperfect information. ESG issues are likely to be at the forefront of stakeholders’ minds when conducting these evaluations of firm behaviour.
A strong reputation offers various benefits, including competitive advantages and the ability to generate product premia. Conversely, the threat of reputation damage can restrict firm behaviour due to its impact on market value and prospects. Therefore, the quantum of reputation damage can be thought of as the loss in value, prospects or market share arising from the event.
In an ESG context, several empirical studies have found positive investor reactions to ESG initiatives including net zero commitments, living wage standardisation and board diversity pledges. It's crucial that such claims are legitimate. Allegations of greenwashing and bluewashing, where it's alleged that claims relating to environmental and responsible social practices are overstated, can result in reputational damage.
Our economics consulting team conducted an event study analysing the impact of reputation damage arising from adverse regulatory finding. We compared actual returns following such findings with an expected return in the counterfactual but-for scenario where no wrongdoing took place. The estimate of counterfactual concerns was based on normal returns before the adverse regulatory finding. (The analysis does not consider any offsetting increase in values or returns arising from the conduct which attracted regulatory scrutiny.)
We used data from 24 UK-based PLCs in the financial industry that had adverse regulatory findings between 2004 and 2013. The data relates to the weeks leading up to and following the point at which regulators disclose the wrongdoing. One example of such wrongdoing is UBS’s 2012 LIBOR-fixing scandal, which triggered a significant decrease in value. The same framework could be used in an ESG setting such as the ESG-related reputational harm caused by BP’s 2010 Deepwater Horizon Spill.
We were able to show that the value lost is disproportionately large when compared with the magnitude of any fines or the importance of any regulatory restrictions on conduct going forward.
This event study approach finds that an announcement by regulators disclosing wrongdoing prompts significant cumulative abnormal losses of 5.43% in share price on average in the two days following the announcement. By subtracting the magnitude of fines as a proportion of firm value from the change in firm value brought about by the regulatory disclosures, we can identify a ‘residual’ reputation effect.
The quantum of fines issued by the regulator is equal to 0.045% of market cap on average, which is dwarfed by the average value of reputational losses which equalled 5.49% of sample firms’ market cap. This equates to £1.15 billion worth of value loss for the average FTSE 100 firm.
These impacts can be seen in Figure 1, which shows the impact of the adverse regulatory announcement. There was a 3.32% fall in value on the day that the sanction was announced (0 on the x-axis) and a further 2.11% on the following day.
Source: Grant Thornton calculations, using data from Yahoo! Finance and Financial Services Authority archives
The role of ESG and firm reputation in determining long-term growth is expanding. Indeed, the Harvard Business Review (May-June 2019 magazine) found that ESG was “almost universally top of mind” for 70 top executives across 43 leading investment firms.
Directors’ duties under the Companies Act 2006 can be summarised as acting to maximise the long-term value of the firm. As the importance of ESG factors increases for consumers, investors and regulators, the relationship between ESG and the value of the firm will grow stronger. In some cases, ESG issues may even be pivotal to the long-term viability of a firm.
From an economic perspective, firms can treat their ESG strategy as a constrained optimisation problem. A constrained optimisation problem is when a firm selects the strategy which maximizes the value of desired outcomes while adhering to any constraints (budgetary and regulatory). In an ESG context, firms select the ESG activities that they invest and engage in so as to maximise profit, employee satisfaction and stakeholder interests. Firms do this subject to regulatory constraints, cost of implementation, and the risk arising from ‘getting it wrong’ – which could include damages and accusations of greenwashing or bluewashing.
Solving this constrained optimisation problem will help ensure your firm is well-positioned to see strong returns on investment relating to ESG. A failure to adequately consider ESG factors would be inconsistent with the fulfilment of director duties under the Companies Act. If such a failure led to adverse strategic decisions which damaged the company’s value, this could leave the director exposed to director’s duties claims.
Event studies are just one tool in our arsenal that could be used to quantify the loss of value arising from such events. To discuss any of these issues further, get in touch with Schellion Horn or Tom Middleton.
