ESG risks can lurk in supply chains, too

Information about ESG risks and practices within firms’ supply chains has traditionally proven difficult to come by—for researchers and companies alike. Image: Shutterstock

You may know whether the company that makes your smartphone has a reputation for strong environmental and social practices. But what about their suppliers—the ones that make the batteries, microchips, and camera lenses?

It’s not just consumers who are in the dark about these firms. Companies themselves often struggle to collect comprehensive information about their supply-chain partners’ employment practices, regulatory compliance, and environmental sustainability.

Regulators around the world have begun to signal that companies need to do a better job of monitoring and disclosing their suppliers’ conduct. For example, the U.K., Australia, and Canada now require companies to report on their efforts to track their suppliers’ labor practices. In the U.S., the Securities and Exchange Commission (SEC) has proposed mandating that American companies disclose the greenhouse gas emissions produced across their supply chains—though companies have pushed back against the proposal, insisting that such data would be prohibitively burdensome to collect.

Should the SEC require companies to find a way to gather and report this supply-chain data, despite the protests? Aaron Yoon, an assistant professor of accounting and information management at the Kellogg School, argues that the answer relies, in part, on whether companies’ shareholders stand to benefit from such disclosure.

“In order for the SEC to actually regulate this information, they need to understand whether it’s decision-useful 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 paper, Yoon returns to a question he’s asked throughout his research—one that’s also at the center of a contentious and increasingly politicized debate: Do firms’ efforts to improve their environmental, social, and governance practices actually generate financial value for shareholders? For the first time in his research, Yoon considers whether the social responsibility of a company’s suppliers is related to that company’s own financial well-being.

Yoon teamed up with Xuanpu Lin and Guoman She of the University of Hong Kong and Haoran Zhu of Southern University of Science and Technology to analyze news reports about negative ESG incidents—like labor violations or revelations of environmental harm—within publicly traded companies’ supply chains. They found a significant link between the level of ESG risk within a company’s supply chain and its future stock returns, with negative ESG news dampening prices.

“Our findings highlight the importance of making supply-chain-related information available to investors,” Yoon says. “It appears that as a long-term value-creating factor, this needs to be better accounted for.”

Uncovering alpha

Yoon and his colleagues decided to investigate a set of publicly traded U.S. companies with sales larger than $1 million, as well as their global vendors, in the years between 2009 and 2020.

Information about ESG risks and practices within firms’ supply chains has traditionally proven difficult to come by—for researchers and companies alike. So, to learn more, the team identified companies’ major suppliers from the FactSet Revere Relationship database. They also gathered data about negative ESG news events involving those suppliers from RepRisk, a data-science firm that collects news reports (and where Yoon serves as an academic adviser).

To discern whether negative ESG events among a company’s suppliers affected that company’s stock price, the researchers compared 12-month windows: Would having a high number of problematic ESG reports across the supply chain in one 12-month period be associated with a lower stock price in the following year?

The researchers’ analysis revealed that the answer was a resounding yes.

Also read: 'Outsourcing' ESG: How mandatory disclosure is affecting supply chains

Next, the researchers decided to quantify the impact. Yoon and his colleagues assigned firms to quartiles 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 short-selling the stocks with the most, the portfolio generated an excess return of 6.77 percent relative to a benchmark portfolio.

Excess return, or alpha, at such a level suggests the presence of valuable, untapped information embedded within data about firms’ supply-chain ESG risk. In other words, the market isn’t yet incorporating this useful information into its understanding of stocks’ expected future performance.

“I was not surprised by the level of alpha we found,” Yoon says, “because when I talked to investors, many had little idea how to collect this data or even how to think about supply-chain ESG issues.”

Decision-useful ESG data

Yoon believes that companies with healthy supply-chain ESG are achieving their stronger performance through three main pathways. First, their supply chains are more stable, thanks to fewer shocks and disruptions. This allows companies to deliver orders on time and ensure sufficient inventory. Second, ethical sourcing appears to attract socially conscious customers and investors and avoid reputational damage. Finally, keeping supply chains squeaky clean helps companies stay ahead of new regulations that mandate better behavior. For example, firms with high supply-chain ESG risk responded with negative market shocks upon the passage of ESG-related laws, like the California Transparency in Supply Chains Act.

And he’s confident that even as ESG investing continues to be politicized and, in some quarters, pegged as a dying strategy, it’s not going anywhere.

“What my research tries to highlight is that there are certain ESG factors and signals that can be taken advantage of from an investor’s perspective,” Yoon says. “Why wouldn’t you use a factor that generates alpha?”

[This article has been republished, with permission, from Kellogg Insight, the faculty research & ideas magazine of Kellogg School of Management at Northwestern University]