It’s not just consumers who are in the dark about these companies. Companies themselves often struggle to collect comprehensive information about their supply chain partners’ employment practices, regulatory compliance and environmental sustainability.
Regulatory authorities around the world have begun to signal that companies need to do a better job of monitoring and disclosing the behavior of their suppliers. For example, the United Kingdom, Australia and Canada now require companies to report on their efforts to monitor the labor practices of their suppliers. In the US, the Securities and Exchange Commission (SEC) has proposed requiring US companies to disclose the greenhouse gas emissions produced in their supply chains—although companies have opposed the proposal, insisting that collecting such data would be prohibitively burdensome.
Should the SEC require companies to find a way to collect and report this supply chain data, despite protests? Aaron Yoonassistant professor of accounting and information management at the Kellogg School, argues that the answer depends, in part, on whether the companies’ shareholders benefit from such disclosure.
“For the SEC to actually regulate this information, they need to understand whether it’s decision-helpful for investors or not,” Yoon says. “If it’s not, maybe the Environmental Protection Agency should regulate it, but not the SEC.”
In a new post, Yoon returns to a question he’s been asked throughout his research—a question that’s also at the center of a controversial and increasingly politicized discussion: Do companies’ efforts to improve their environmental, social and governance practices actually create financial value for shareholders? For the first time in his research, Yoon examines whether the social responsibility of a company’s suppliers is related to the financial well-being of the company itself.
Yoon collaborated with Xuanpu Lin and Guoman She of the University of Hong Kong and Haoran Zhu of the Southern University of Science and Technology to analyze news about negative ESG incidents—such as labor violations or disclosures of environmental harm—within the supply chains of listed companies. They found a significant relationship between the level of ESG risk in a company’s supply chain and its future stock returns, with negative ESG news depressing prices.
“Our findings highlight the importance of making supply chain-related information available to investors,” says Yoon. “It seems that as a factor of long-term value creation, this should be better taken into account.”
Alpha reveal
Yoon and his colleagues decided to investigate a number of US publicly traded companies with sales greater than $1 million, as well as their global suppliers, between 2009 and 2020.
Information about ESG risks and practices in companies’ supply chains has traditionally proved difficult to find — both for researchers and companies. So to learn more, the team identified the companies’ major suppliers from the FactSet Revere Relationship database. They also collected data on negative ESG news events involving these suppliers from RepRisk, a data science firm that collects news reports (and where Yoon serves as an academic advisor).
To discern whether negative ESG events among a company’s suppliers affected that company’s stock price, the researchers compared 12-month windows: Will having a large number of problematic ESG reports across the supply chain in a 12-month period be associated with a lower stock price the following year?
The researchers’ analysis revealed that the answer was a resounding yes.
The researchers then set out to quantify the impact. Yoon and his colleagues assigned companies to quadrants based on the level of ESG risk within their supply chains and used this information to create a hypothetical portfolio. By investing in the stocks with the least ESG supply chain risk and selling the stocks with the most, the portfolio generated an excess return of 6.77 percent over a benchmark portfolio.
Excess performance, or alpha, at such a level indicates the presence of valuable, untapped information embedded in the data about the ESG risk of firms’ supply chains. In other words, the market has not yet incorporated this useful information into its understanding of expected future stock performance.
“I wasn’t surprised by the level of alpha we found,” says Yoon, “because when I talked to investors, many had no idea how to collect this data or even how to think about supply chain ESG issues.”
Useful ESG data for decision making
Yoon believes that companies with a healthy ESG supply chain achieve their strongest performance through three main avenues. First, their supply chains are more stable, thanks to fewer shocks and disruptions. This allows companies to deliver orders on time and ensure adequate inventory. Second, ethical sourcing appears to attract socially conscious customers and investors and avoid reputational damage. Finally, keeping supply chains clean helps companies stay ahead of new regulations that demand better behavior. For example, companies with high supply chain ESG risk responded with negative market shocks after ESG-related laws were passedsuch as the California Transparency in Supply Chains Act.
And he is confident that even as ESG investing continues to be politicized and, in some quarters, linked as dying strategyit’s not going anywhere.
“What my research is trying to highlight is that there are certain ESG factors and signals that can be leveraged from an investor’s perspective,” says Yoon. “Why wouldn’t you use an alpha generator?”
