03 March 2021 COVID | Equities

How Can ESG Ratings Affect an IPO Stock Valuation?

Summary

A new Journal of Corporate Finance paper shows that higher country-level ESG ratings are associated with lower IPO underpricing.
IPOs issued in countries with more transparent accounting disclosures, greater liability standards, and stronger shareholder protections are less likely to be priced below their real value.
The relationship between ESG Government Ratings and IPO underpricing is greater in countries with high liability standards and strong shareholder rights.

ESG Investing and Stock IPO Listings

ESG investing has been around for a while. But a firm’s environmental, social, and governance (ESG) profile appears increasingly linked to financial outcomes. Investors are therefore considering ESG factors alongside more traditional financial variables when making investment decisions. This includes initial public offering (IPO) listings, where information disparities often result in significant mispricing. A new Journal of Corporate Finance paper examines whether country-level ESG ratings can affect IPO valuations. They find:

Firms undergoing IPO conform to the ESG norms of their listed country, and higher MSCI ESG Government Ratings reduce IPO underpricing.
A one standard deviation improvement in a country’s ESG Government Rating is associated with a 7.07ppt decrease in first-day returns for IPOs that occur in that country.
Underpricing tends to be lower in countries with stronger environmental risk management practices, e.g., countries with better water and/or energy resource management.
Lastly, the negative relation between ESG ratings and underpricing is stronger in countries with higher liability standards and stronger shareholder protections.

Motivation – Is Underpricing Endemic Among High-ESG Firms?

ESG investing is often a murky endeavour. But so is IPO investing. Information about IPO issuers is often limited because, as private firms prior to the IPO event, they face less stringent disclosure requirements. This creates information asymmetries between issuers and underwriters, issuers and investors, and different investor groups.

It is unclear whether mispricing is more endemic among firms with a high ESG score. On one hand, a higher ESG score means firms are more ethical and transparent and attract greater attention from stock analysts and the media. This could reduce information asymmetries. Alternatively, greater attention and demand increase the likelihood of buying frenzies on the first day of trading, which can lead to greater underpricing for firms with a good ESG score.

The authors analyse which force dominates. If it is the former, then ESG ratings contain value-relevant information about IPO firms. If it is the latter, there is more investor attention, leading to IPO underpricing, for high-scoring ESG firms.

Methodology: Finding ESG Ratings and IPO Firm Information

Private firms are unlikely to possess firm-level ESG ratings prior to becoming public. However, research shows that firms undergoing IPO conform to the ESG norms of their listing country. This is because institutional investors interact with firms and their representatives during the roadshow and often receive significant allocations of IPO shares, meaning they are in a position to influence IPO firms’ ESG policies.

The authors therefore use a country’s performance on ESG issues to proxy firm-level ESG policies. For this, they collect the MSCI’s Government Ratings, which evaluate a country’s exposure to and management of ESG risk factors that may affect the long-term sustainability of its economy. It has three underlying measures that consider ESG risks. Beneath each pillar are multiple risk factors and sub-factors that address a country’s exposure to and management of each type of risk (Chart 1).

The paper focuses only on the individual risk management pillars: Environmental Risk Management (RM), Social RM, and Governance RM. The authors say this is because ‘it is often the case that a country’s exposure to ESG risk is a function of resource endowments and other factors beyond the country’s control. However, countries can pursue strategies to effectively manage these risks in order to improve their competitiveness and economic sustainability.’

In all, the authors collect 7,446 IPOs and ESG Government Ratings from 36 countries between 2008 and 2018. IPO data is taken from the Thomson Financial SDC Platinum New Issues database, excluding closed-end funds, depositary receipts, financial firms, limited partnerships, rights offerings, trusts, and unit offerings. They use the SEDOL identifier to match IPO events to Datastream to retrieve secondary market closing prices. They use these prices to calculate first-day returns as the difference between the first-day secondary market closing price and the IPO offer price, divided by the IPO offer price.

Results: High ESG Ratings Mean Accurate IPO Valuations for Some

The main result is that underpricing is lower in countries with higher ESG Government Ratings. A one standard deviation improvement in a country’s ESG Government Rating, equivalent to a move from Malaysia to Germany based on their 2018 ratings, is associated with a 7.07ppt decrease in underpricing.

Furthermore, first-day returns tend to be significantly lower in countries with higher Environmental RM scores. These countries have better management of risks associated with environmental externalities and vulnerabilities and with natural resources.

The strongest negative association is between the social risk factor and underpricing. A one standard deviation improvement in Social RM is associated with initial returns that are 14.19ppt lower. Meanwhile, a one standard deviation improvement in Governance RM translates to initial returns that are 2.28ppt lower.

These results suggest that country-level ESG ratings have value-relevant information about firms. This is consistent with the notion that higher ESG ratings foster lower information asymmetry. In other words, high-ESG firms issuing IPOs in countries with high ESG norms are more likely to be accurately valued.

Results – Laws and Rights Around the IPO

Finally, the authors look at the liability standards and shareholder rights in a particular country to see whether this influences the negative relationship.

Studies have shown that firm-level ESG scores vary systematically by legal origin, with firms from civil law countries scoring significantly higher on various ESG dimensions than their common-law peers. This is said to be because of the lower litigation risk in civil law countries. On this front, the authors find that countries with high liability standards increase the strength of the relationship between ESG ratings and underpricing.

Lastly, regulations related to stakeholder welfare could also help explain why firm-level ESG scores vary systematically by legal origin. The results show that, while higher ESG ratings are associated with lower first-day returns, this is particularly the case when accompanied by stronger shareholder protections.

High ESG Ratings Positively Affect IPO Valuations

ESG factors have a positive impact on firms’ financial and stock market performance because of factors such as customer loyalty, trust and long-term sustainability. This makes high-ESG firms appealing to investors. The paper is unique in showing that ESG ratings provide value-relevant information around new stock issues. For policymakers and regulators, this gives weight to mandating ESG disclosures ahead of IPOs. For investors, this suggests that high-ESG firm IPOs are less likely to be mispriced.

Citation

Baker, E. et al (2021) ‘ESG government risk and international IPO underpricing’, Journal of Corporate Finance, (101913) https://www.sciencedirect.com/science/article/pii/S0929119921000341