Take it with a pinch of salt—ESG rating of stocks and stock indices

This paper investigates the environmental, social, and governance (ESG) ratings of 20 leading stock exchange indices by analyzing and aggregating ratings of underlying stocks. ESG ratings are increasingly important inputs to sustainable investments in the European Union and United States with the phasing-in disclosure regulations. We find that ratings from two different rating providers (Sustainalytics and Refinitiv) for the same listed stocks are only weakly correlated, even if the scaling differences of the ratings are adjusted. Monte Carlo simulations are conducted to estimate how the choice of major ESG rating inputs (i) aggregation formula, (ii) weighting scheme and (iii) data provider influence the uncertainty of ratings and thus indirectly the sustainable investment process. The simulations reveal that the uncertainty is primarily related to choice of the ESG rating provider. We found that the popular best-in-class portfolio selection could be built on ESG scores. In lower segments of the ESG asset universe, investment selection becomes more challenging due to the increasing uncertainty of ratings. Finally, the paper shows that exchanges in the European Union provide relatively good ESG investment opportunities in international comparison.     

The wages of social responsibility — where are they? A critical review of ESG investing

This paper contributes both to investigating the link between the corporate social and financial performance based on environmental, social and corporate governance (ESG) ratings and to reviewing the existing empirical evidence pertaining to this relationship. The sample used includes ESG data of ASSET4, Bloomberg and KLD for the U.S. market from 1991 to 2012. The econometrical framework applies an ESG portfolio approach using the Carhart (1997) four-factor model as well as cross-sectional Fama and MacBeth (1973) regressions. Previous empirical research indicates a relationship between ESG ratings and returns. As against this, the ESG portfolios do not state a significant return difference between companies with high and low ESG ratings. Although the Fama and MacBeth (1973) regressions reveal a significant influence of several ESG variables, investors are hardly able to exploit this relationship. The magnitude and direction of the impact are substantially dependent on the rating provider, the company sample and the particular subperiod. The results suggest that investors should no longer expect abnormal returns by trading a difference portfolio of high and low rated firms with regard to ESG aspects.     

ESG in credit ratings and the impact on financial markets

This study examines environment, social, governance (ESG) consideration in rating reports published by credit rating agencies. 3,719 Moody's credit rating reports between 2004 and 2015 are examined and the ESG consideration is analyzed using a latent dirichlet allocation (LDA) approach. We further analyze the stock returns and credit default swap (CDS) spread changes to check whether ESG consideration has an effect on the capital market reactions. We find a small but present consideration of ESG in rating decisions. Within ESG, corporate governance plays the most important role. Moreover, the results reveal that ESG consideration is a significant determinant in the stock return and CDS spread around the rating announcement. We find that all ESG criteria are important for equity and debt investors.     

Do ESG ratings promote corporate green innovation? A quasi-natural experiment based on SynTao Green Finance's ESG ratings

Corporate efforts in green technology improvements are critical for enhancing sustainability; consequently, how to promote green innovation has attracted scholarly attention. This study explores whether and how environment, social, and governance (ESG) ratings influence corporate green innovation by using an independent third-party rating agency's (SynTao Green Finance) ESG ratings in China as a quasi-natural experiment. We find companies covered by the ESG rating agency significantly increase green innovation output by 3.9%, mainly as an increase in green invention patents. ESG ratings' positive effects on green innovation are more pronounced for firms whose investors are less short-sighted, non-state-owned enterprises and firms with higher degree of financial constraints. Additionally, we find ESG ratings' impact can also increase the green innovation quality and synergetic green innovation. Thus, ESG ratings from third-party institutions can effectively increase corporate green innovation, which has important implications for companies to achieve green transformation and for emerging markets to improve ESG rating systems.     

Sustainability and sovereign credit risk

The study investigates the impact of Environmental, Social, and Governance (ESG) ratings on sovereign credit risk. The study measures sovereign credit risk using a market-based, structural and an analyst-based approach, while ESG scores are obtained from three different rating agencies. The contributions of this paper are multifold. First, we discover that higher sustainability performance at the corporate level significantly decreases market-based (CDS spreads) and structural (Distance-to-default) sovereign credit risk but has no consistent impact on analyst-based (Credit ratings) sovereign credit risk measure. Second, by expanding our research to include the concept of financial materiality based on the SASB materiality map, we break down and highlight the sustainability themes that require the most attention at the sovereign level and those that can affect the credit health of countries. Third, we demonstrate that the relationship between sustainability and sovereign credit risk varies across ESG rating providers, supporting the widespread belief that sustainability metrics lack standardization and are difficult to compare across providers.     

Secret Recipe of IPO survival: ESG disclosure and performance

While ESG initiation and disclosure may help newly listed companies maintain a social license to operate, mitigate information asymmetry, and attract investor attention, it may impose significant costs on initial public offering (IPO) firms and magnify agency problems. Using a sample of 1102 IPOs issued in the U.S and the ESG data from MSCI between 1999 and 2016, the paper empirically tests the competing hypotheses and examines the influence of ESG disclosure and performance on the survivability of IPOs. We document that (1) voluntary ESG disclosure reduces IPO failure risks and improves long-run performance of IPO; (2) the sooner ESG information is disclosed after the IPO, the greater the likelihood of survival and better long-run performance; and (3) IPOs with better ESG score are less likely to fail, with the impact largely attributable to the company's social and governance performance. Our findings identify new failure risks for IPOs, supply evidence of value-relevance of ESG, and provide practical guidance for managers.     

Is it costly to be both shariah compliant and socially responsible?

Positive ethics associated with socially responsible investments (SRI) is challenging the limits of Islamic investments' conservative approach to promote corporate social responsibility. In this study, we test the integration of social performance measures (companies the most virtuous or high-rated in terms of environmental, social, and governance (ESG) issues) in Islamic portfolios using KLD social ratings. We seek to determine the financial price of complying both to Islamic investment and SRI principles. To do so, we measure the financial performance of self-composed Islamic portfolios with varying ESG scores. The results indicate no adverse effects on returns due to the application of ESG screens on shariah-compliant stocks during the 2007–2011 periods while reporting substantially higher performance for the portfolios with good records in governance, products, diversity, and environment issues. On the opposite, a negative performance is associated with an SRI strategy of disengagement from shariah-compliant stocks with community and human rights controversies. Our performance measures are controlled for market sensitivity, investment style, momentum factor, and sector exposure.     

ESG Controversies,ESG Disclosure and Analyst Forecast Accuracy

We investigate whether an environmental social governance (ESG) disclosure moderates the relation between ESG controversies and analyst forecast accuracy. The previous literature has shown that ESG controversies increase uncertainty about a firm's future prospects, while ESG disclosure decreases this uncertainty. We therefore take the next step and integrate ESG controversies, ESG disclosure and uncertainty into one model. Our study is based on 8,369 firm-year observations across 51 countries from 2008 to 2017, containing data from RepRisk, Bloomberg and the Institutional Brokers' Estimate System. We find that analyst forecast errors are generally higher for firms with higher exposure to ESG controversies. More importantly, we establish ESG disclosure as a moderator that mitigates the strength of the relation between ESG controversies and analyst forecast errors. Additionally, we identify that the most important pillar for the relation derives from social controversies and disclosure.     

Executive Compensation Tied to ESG Performance: International Evidence

Using a wide sample of international publicly traded firms, this paper studies the rapidly increasing practice of incorporating Environmental, Social, and Governance (ESG) metrics in executive compensation contracts. Our evidence suggests that this compensation practice varies at the country, industry, and firm levels in ways that are consistent with efficient incentive contracting. We also observe that reliance on ESG metrics in executive compensation arrangements is associated with engagement, voting, and trading by institutional investors, which suggests that firms could be adopting this practice to align their management's objectives with the preferences of certain shareholder groups. Finally, we find that the adoption of ESG Pay is accompanied by improvements in key ESG outcomes, but not by improvements in financial performance.     

Greenwashing in environmental,social and governance disclosures

The environmental, social, and governance (ESG) data provided in firms’ sustainability reports is often unaudited. If ESG information disclosed by firms is not reliable, a firm’s greenwashing behavior can be a barrier to integrating ESG factors into investment decisions. In this paper, we study mechanisms to lessen firms’ greenwashing behavior in ESG dimensions holistically. Firstly, we identify “greenwashers” as firms which seem very transparent and reveal large quantities of ESG data but perform poorly in ESG aspects. By creating peer-relative greenwashing scores for a cross-country dataset comprised by 1925 large-cap firms, we measure the extent to which large-cap firms engage in greenwashing. We find evidence that greenwashing behavior in ESG dimensions can be deterred by scrutiny from (a) independent directors, (b) institutional investors, (c) influential public interests via a less corrupted country system, and (d) being cross-listed. Our results suggest that the two firm-level governance factors are most effective at attenuating firms’ misleading disclosure relating to ESG dimensions.     

Stock market reactions to adverse ESG disclosure via media channels

This study examines the value relevance of corporate reputation risks (CRR) from adverse media coverage of environmental, social and governance (ESG) issues on stock performance at the firm level. Empirical results advance signalling theory and resource-based view by providing evidence that corporate reputation is considered a valuable intangible asset by investors and adverse ESG disclosure via media channels have a significant and negative impact on firm valuation. The research is extended using various factors and indicates that heightened CRR have a substantially negative corollary effect on stock price of smaller and less liquid firms that are typically not S&P500 constituents. Further analysis using industry classifications reveals that stock performance of companies in the ‘sin’ triumvirate (i.e., alcohol, tobacco, and gaming) is not significantly affected by negative ESG media coverage. Instead, firms in candy & soda, steel works, banking, and insurance industries are the most susceptible to investors' repercussion from undesirable media spotlight. These findings provide new insights and indicate that beyond the type and delivery method of ESG disclosures, firm characteristics, corporate reputation status and industry explain differences in investors' reaction to ‘bad’ news.     

The impact of institutional investors on ESG: Evidence from China

This paper studies the influence of institutional ownership on the Chinese A-shares' ESG performance. Findings reveal the positive improvement from institutional investors, and this impact is stronger in firms with better-expected ESG performance and low initial ESG performance. Besides, heterogeneous institutional investors have different influences, and only a pressure-resistant institution plays the promotion role. Further studies based on the period following the financial crisis and when emphasising the environmental protection policy reveal that financial motivation and reputation motivation could be the reason for institutional holding. Our findings are robust after using the instrumental variable analysis, controlling for firm fixed effects, and replacing institutional holdings, and could be beneficial for the governance of firms in China.     

Is sustainability rating material to the market?

This study examines whether information about a firm's engagement in environmental, social, and governance (ESG) practices is material to market participants. Evidence from a sample of 1856 initial public offerings (IPOs) by U.S. companies for the 2007–2018 period robustly documents that firms for which there is available ESG performance information prior to going public exhibit higher underpricing due to a positive market response. Such a reaction is validated by agency cost-reducing practices that ESG-rated firms follow prior to the IPO, the superior post-IPO market performance they exhibit in terms of equity financing, and the higher share of financially sophisticated investors they attract compared to their ESG-unrated peers. Overall, our results highlight that it pays off to do good and to have the right investors; however, firms’ good ESG practices need to be visible to the market, through rating practices, to reap the benefits.     

“Non‐Financial” Is a Misnomer,but Doesn't Have to Be a Missed Opportunity

With enterprise values now representing increasing multiples of companies' net book assets, investors are clearly looking beyond financial reporting for enhanced insights and understanding of when and how companies are adding value. This shift includes growing attention to environmental, social, and governance (ESG) information. Although ESG data presents its own unique challenges, dismissing it as “non‐financial” can be misleading. When explicitly linked to a company's long‐term value creation strategy, ESG information can serve as a valuable input to more farsighted financial analysis. Market‐driven initiatives, notably that of the Sustainability Accounting Standards Board (SASB), aim to standardize a subset of business‐critical, industry‐specific sustainability data for investors. Research indicates such approaches can generate positive outcomes not only for providers of financial capital, but for their portfolio companies and markets in general. In illustrating these concepts, the authors explore ESG impacts in three sectors and industries, while examining how access to consistent, comparable, reliable sustainability information in those sectors can augment an analysis of traditional business fundamentals. One example focuses on water management in the Oil & Gas Exploration & Production industry, a major environmental issue where geographic considerations can shed light on company‐specific exposures to cost increases, production disruptions, increased CapEx and R&D spending, as well as the potential for asset write‐downs. In the Food & Beverage sector, health and nutrition concerns are shown to be changing consumer preferences, triggering regulatory action, and reshaping companies' product portfolios—with significant implications for the companies' brand values and ability to compete for market share. Finally, in Aerospace & Defense, lapses in business ethics such as bribery of government officials present a governance challenge that comes with the risk of value‐destroying fines and penalties and, even more significant, associated reductions in revenues.     

ESG preferences,risk and return

There are two primary factors that affect expected returns for companies with high ESG (environmental, social and governance) ratings—investor preferences and risk. Although investor preferences for highly rated ESG companies can lower the cost of capital, the flip side of the coin is lower expected returns for investors. Regarding risk, the jury remains out on whether there is an ESG-related risk factor. However, to the extent, ESG is a risk factor it also points towards lower expected returns for investments in highly rated companies. Though ESG investing may have social benefits, higher expected returns for investors are not among them.     

Sustainability priorities,corporate strategy,and investor behavior

Using a sequential experiment, this study examines whether integration of material environmental, social, and governance (ESG) priorities into corporate strategy impacts investors’ short‐ and long‐term stock price assessments and investment allocation. In our examination, we consider the potential moderating effect of financial performance. We find that integration of ESG priorities into strategy does not have a significant effect on investors’ price assessments or investment allocation. This is true regardless of the trend in the company's financial performance. Our results hold across various demographics and the levels of investment knowledge and investment experience. Investors’ perception of relevance and reliability of material ESG information, however, has a mediating effect on their long‐term price assessment and investment allocation. Overall, our findings suggest that any future requirements on disclosure of ESG information by regulators and standard setters should aim to improve investors’ perception of the relevance and reliability of that information.     

Market Interest in Nonfinancial Information

During the past two decades, more and more companies have volunteered to provide “corporate social responsibility” or “sustainability” reports that include information about their environmental, social, and governance (ESG) policies and performance. Such reporting has come about largely in response to demands by a wide range of stakeholders for information about how the company's operations are affecting society in a number of different ways. But do investors really care about companies' ESG performance and policies? Using data from Bloomberg, the authors provide the first broadly based empirical evidence of investors' interest in ESG data. More specifically, the authors show how interest in the top 20 ESG metrics varies with geographical location (European vs. American), asset class (fixed income vs. equity), and firm type. At the aggregate market level, there is greater interest in environmental and governance information than in “social” information. U.S. investors are more interested than their European counterparts in governance and less interested in environmental information. Equity investors are interested in a wider range of nonfinancial information than are fixed income investors. And whereas sell‐side analysts are primarily interested in greenhouse gas emissions, money managers tend to focus on a broader set of metrics. Similarly, pension funds and hedge funds have shown interest in more nonfinancial metrics than insurance companies. The authors' bottom line: Companies need to recognize the growing market interest in nonfinancial information and ensure that they are providing it according to the specific information needs of market users.     

ESG,risk, and (tail) dependence

While environmental, social, and governance (ESG) trading activity has been a distinctive feature of financial markets, the debate if ESG scores can also convey information regarding a company’s riskiness remains open. Regulatory authorities, such as the European Banking Authority (EBA), have acknowledged that ESG factors can contribute to risk. Therefore, it is important to model such risk dependencies and quantify what part of a company’s riskiness can be attributed to the ESG scores. This paper aims to question whether ESG scores can be used to provide information on (tail) riskiness. By analyzing the (tail) dependence structure of companies with a range of ESG scores, that is within an ESG rating class, using high-dimensional vine copula modeling, we are able to show that risk can also depend on and be directly associated with a specific ESG rating class. Empirical findings on real-world data show positive not negligible ESG risks determined by ESG scores, especially during the 2008 crisis.     

When do ESG controversies reduce firm value in India?

This study investigates whether, when, and how media coverage of environment, social, and governance (ESG) controversies, type of media reach, and media severity affects firm value in India's emerging and developing market. By anchoring enacted sensemaking theory with agenda-setting theory and attribution theory, we offer the first investigation of how firm value is impacted by the reach and severity of ESG controversies in the context of voice and accountability (VA). Drawing on a comprehensive dataset for 2007–2016, this study reveals the critical condition for ESG controversies to impact firm value. The media coverage of ESG controversies decreases firm value only when the media reach is high, as high reach has a more distributable capacity and greater situated cognition magnitude. On the other hand, media coverage could enhance firm value when the severity is high, as higher severity results in sensemaking intensification that lowers crisis severity. Upon reflection on these results, our study reveals that the fundamental media machinery expected to control ESG controversies is possibly much more fragile than formerly understood. Therefore, mere media reporting of ESG controversies does not overtly lead to stakeholders' sanctions and valuation effects.     

When ESG talks: ESG tone of 10-K reports and its significance to stock markets

Since the ESG topic consistently gains on importance in the investment universe, companies provide investors with information regarding recent and future ESG activities through different reporting channels. The most recent research finds relevance of ESG-related corporate activities for formation of investors' opinion regarding companies' valuations and growth prospects. Based on a sample of more than seventeen thousand unique 10-K reports of US companies filed with SEC in period 2013 to 2019 and the word-power methodology proposed by Jegadeesh and Wu (2013), this study also shows evidence for significant relation of ESG textual tone of 10-K reports to stock market returns of filing companies around the report filing dates. Using the ESG linguistic dictionary recently proposed by Baier, Berninger, and Kiesel (2020), this study shows evidence for significant relation of social and governance-related topics disclosure to stock returns, while environmental narratives being ignored by the markets. When looking at individual words from the ESG lexicon, such words as “community”, “health”, “control” imply positive reaction of markets, while “discrimination”, “embezzlement”, and “crime” are related to negative returns. The robustness analysis based on the inverse document frequency word weightings and actual ESG performance scores confirms the significance of ESG information disclosure of 10-K reports for investors. Thus, this study sheds light on the mechanics of ESG information perception and its influence on capital markets.