ESG for All? The Impact of ESG Screening on Return,Risk, and Diversification

A large body of research has documented a positive relationship between different measures of sustainability—such as indicators of employee satisfaction and effective corporate governance—and corporate financial performance. Nevertheless, many investors still struggle to quantify the value of ESG to investment performance. To address this issue, the authors tested the effects of using different ESG filters on an investable universe that serves as the starting point for a fund manager. In this way, they attempted to determine the extent to which ESG data can add value to any investment approach, regardless of preferences towards sustainable investing. The authors report “an unequivocally positive” contribution to risk‐adjusted returns when using a 10% best‐in‐class ESG screening approach (one that effectively removes companies with the lowest 10% of ESG rankings), both on a global and a developed markets universe. More specifically, as a result of such screening, both the global and developed markets portfolios show higher returns, lower (tail) risk, and no significant reduction of diversification potential despite the reduction in the number of companies. Use of a 25% screening filter was also found to add value, especially by reducing tail risks, but with a larger deviation from the unscreened universe. Overall, then, the authors’ finding is that the incorporation of ESG information contributes to better decision‐making in every investment approach, with the optimal configuration depending on a fund manager's preferences and willingness to deviate from an unscreened benchmark.     

Environmental,social, and governance practices and perceived tail risk

Using the implied volatility smirk on individual equity securities to measure perceived tail risk, we find that better environmental, social and governance (ESG) practices significantly reduce ex-ante expectations of a left-tail event. Our findings are robust to using multiple model specifications and to adjusting for potential endogeneity concerns. We also show that, while practices in each ESG pillar are important in reducing perceived tail risk, the environmental pillar plays the most important role. Our results indicate that investors consider strong ESG practices to be insurance against left-tail events rather than wasteful investment borne out of managers’ own values or self-interest.     

Issuing bonds during the Covid-19 pandemic: Was there an ESG premium?

We rely on the ESG ratings assigned by four distinct agencies (MSCI, Refinitiv, Robeco, and Sustainalytics) to study the link between ESG scores and firms’ cost of debt financing during the Covid-19 pandemic. We document the existence of a statistically and economically significant ESG premium, i.e. better rated companies access debt at a lower cost. Despite some differences across rating agencies, this result is robust to additional controls for the issuer’s credit standing as well as several bond and issuer’s characteristics. We find that this effect is mainly driven by firms domiciled in advanced economies, whereas creditworthiness considerations prevail for firms in emerging markets. Lastly, we show that the lower cost of capital for highly rated ESG firms is explained both by investors’ preference for more sustainable assets and by risk-based considerations unrelated to firms’ creditworthiness, such as exposure to climate change risks.     

Analysts' Roundtable on Integrating ESG into Investment Decision‐Making

In this third of the three discussions that took place at the SASB 2016 Symposium, practitioners of a broad range of investment approaches—active as well as passive in both equities and fixed‐income—explain how and why they use ESG information when evaluating companies and making their investment decisions. There was general agreement that successful ESG investing depends on integrating ESG factors with the methods and data of traditional “fundamental” financial statement analysis. And in support of this claim, a number of the panelists noted that some of the world's best “business value investors,” including Warren Buffett, have long incorporated environmental, social, and governance considerations into their investment decision‐making. In the analysis of such active fundamental investors, ESG concerns tend to show up as risk factors that can translate into higher costs of capital and lower values. And companies' effectiveness in managing such factors, as ref lected in high ESG scores and rankings, is viewed by many fundamental investors as an indicator of management “quality,” a reliable demonstration of the corporate commitment to investing in the company's future. Moreover, some fixed‐income investors are equally if not more concerned than equity investors about ESG exposures. ESG factors can have pronounced effects on performance by generating “tail risks” that can materialize in both going‐concern and default scenarios. And the rating agencies have long attempted to reflect some of these risks in their analysis, though with mixed success. What is relatively new, however, is the frequency with which fixed income investors are engaging companies on ESG topics. And even large institutional investors with heavily indexed portfolios have become more aggressive in engaging their portfolio companies on ESG issues. Although the traditional ESG filters used by such investors were designed mainly just to screen out tobacco, firearms, and other “sin” shares from equity portfolios, investors' interest in “tilting” their portfolios toward positive sustainability factors, in the form of lowcarbon and gender‐balanced ETFs and other kinds of “smart beta” portfolios, has gained considerable momentum.     

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.     

Does the severity of a client’s negative environmental,social and governance reputation affect audit effort and audit quality?

In recent years, investors have begun to value companies’ reputations through their environmental, social, and governance (ESG) practices. ESG risk can affect business processes and controls and can heighten financial risk and threaten a firm’s survival. This study examines whether and how the severity of media coverage of a firm’s negative ESG issues (tainted ESG reputation) is associated with audit effort and audit quality. I find that auditors manage the higher expected engagement risk conveyed by tainted ESG reputation by applying higher audit effort. Next, I observe that the increased effort is associated with auditors likely detecting and requiring adjustments for material misstatements and that tainted ESG reputation is associated with fewer misstatements (i.e., reduces poor audit quality). The association between tainted ESG reputation and audit quality is driven primarily by increased audit report lag, not by increased audit fees. Further, I find that tainted ESG reputation is positively associated with audit effort and reduces poor audit quality for up to three years. The results also show that the audit effort and audit quality effect vary across the three components of ESG.     

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.     

Four Things No One Will Tell You About ESG Data

As the ESG finance field and the use of ESG data in investment decision‐making continue to grow, the authors seek to shed light on several important aspects of ESG measurement and data. This article is intended to provide a useful guide for the rapidly rising number of people entering the field. The authors focus on the following:

1. The sheer variety, and inconsistency, of the data and measures, and of how companies report them. Listing more than 20 different ways companies report their employee health and safety data, the authors show how such inconsistencies lead to significantly different results when looking at the same group of companies.
2. ‘Benchmarking,’ or how data providers define companies' peer groups, can be crucial in determining the performance ranking of a company. The lack of transparency among data providers about peer group components and observed ranges for ESG metrics creates market‐wide inconsistencies and undermines their reliability.
3. The differences in the imputation methods used by ESG researchers and analysts to deal with vast ‘data gaps’ that span ranges of companies and time periods for different ESG metrics can cause large ‘disagreements’ among the providers, with different gap‐filling approaches leading to big discrepancies.
4. The disagreements among ESG data providers are not only large, but actually increase with the quantity of publicly available information. Citing a recent study showing that companies that provide more ESG disclosure tend to have more variation in their ESG ratings, the authors interpret this finding as clear evidence of the need for ‘a clearer understanding of what different ESG metrics might tell us and how they might best be institutionalized for assessing corporate performance.’

What can be done to address these problems with ESG data? Companies should ‘take control of the ESG data narrative’ by proactively shaping disclosure instead of being overwhelmed by survey requests. To that end, companies should ‘customize’ their metrics to some extent, while at the same time seeking to self‐regulate by reaching agreement with industry peers on a ‘reasonable baseline’ of standardized ESG metrics designed to achieve comparability. Investors are urged to push for more meaningful ESG disclosure by narrowing the demand for ESG data into somewhat more standardized, but still manageable metrics. Stock exchanges should consider issuing—and perhaps even mandating—guidelines for ESG disclosures designed in collaboration with companies, investors, and regulators. And data providers should come to agreement on best practices and become as transparent as possible about their methodologies and the reliability of their data.     

Consequences matter, ‘risk’ is marginal

Critical comments by Palm and Slovic on a previous article of mine (L. Sjöberg, Consequences of perceived risk: demand for mitigation, Journal of Risk Research 2, 129–149) are discussed. Palm’s arguments are largely based on misreading of my article, and her own studies, which she described in detail, are largely irrelevant in the present discussion. Slovic’s arguments are met by pointing out that the many references he cites in favour of his standpoint are mostly quite misleading and irrelevant. Furthermore, I present two new studies where the riskiness of activities was investigated, as well as the risk of unwanted events caused by such activities. All results very clearly support the conclusion that seriousness of consequences is a more important determinant of demand for risk mitigation than risk or probability of unwanted events, or riskiness of activities that can lead to such events.     

Corporate social responsibility and Eurozone corporate bonds: The moderating role of country sustainability

In this paper, we empirically examine whether superior performance in corporate social responsibility (CSR) results in lower credit risk, measured by credit ratings and zero-volatility spreads (z-spreads). We are especially interested in how the environmental, social, and governance (ESG) related performance of the corresponding countries moderates this relationship. We find only weak evidence that superior corporate social performance (CSP) results in systematically reduced credit risk. However, we do find strong support for our hypothesis that a country’s ESG performance moderates the CSP–credit risk relationship. Superior CSP is regarded as risk-reducing and rewarded with better ratings and lower z-spreads only if it is recognized by the environment. In addition, we find a reduction of corporate bonds’ z-spreads by approx. 9.64 basis points if the CSP of a company mirrors the ESG performance of the country it is located in.     

“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.     

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.     

A Preliminary Analysis of SASB Reporting: Disclosure Topics,Financial Relevance,and the Financial Intensity of ESG Materiality

At the end of 2018, the Sustainability Accounting Standards Board (SASB) released its corporate reporting standards for material environment, social, and governance (ESG) issues. These SASB standards are analogous to FASB's but deal with ESG activities that help the companies create value over the long term and have been endorsed by large asset management firms such as BlackRock. The authors analyze the quality of ESG reporting by the 91 companies that adopted SASB's framework. While the number of such companies is still small, their results are encouraging, an indication of better things to come. Using three measures of effectiveness, Disclosure Topic Compliance Index (DTCI), Financial Relevance Compliance Index (FRCI), and Financial Intensity Compliance Index (FICI), the authors found that most companies are doing a good to very good job of reporting and companies tend to focus on measures with the highest financial relevance. Scores on these three measures were similar across industry sectors except for a few cases where the DTCI score is low. They presented cases of three SASB standard companies: 1) Sunrun, a residential solar panel company that uses some hazardous materials, 2) Suncor, an integrated oil and gas company, and 3) Target, a retail company in a highly competitive industry needing to keep costs low while also managing an extensive supply chain responsibly. These 91 companies have demonstrated that reporting according to SASB standards can be done well. This success should encourage other companies to follow and the authors offer a seven‐step process to adopt SASB standards.     

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.     

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.     

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.     

The impact of the ESG disclosure on sell-side analysts’ target prices: The new era post Paris agreements

We examine whether the ESG disclosure is a value driver for sell-side analysts, focusing on the largest 3000 US listed firms between 2012 and 2020. ESG represents Environmental factors, long-term Social factors, and Governance issues. These factors affect a community’s long-term sustainability and serve to guide the broader financial markets, increasingly oriented towards sustainable investing. Specifically, we question whether firms exhibiting higher disclosure scores show higher target prices. Moreover, we investigate the impact of the 2015 Paris agreements addressing climate change on stock’s evaluations. We find that: (1) analysts recognize a premium for firms more engaged in ESG transparency (2) before the Paris agreements this premium is mainly driven by Governance disclosure; (3) after the event this premium is also driven by Environmental disclosure. To the extent that we control for different model specifications, our findings suggest that ESG disclosure is a strategic tool for firms to create value.     

Environmental,social, and governance premium in Chinese stock markets

Financial markets have increasingly adopted the concept of ESG (environmental, social, and governance); this paper studies the evolving effect of corporate ESG performance on the stock returns in China's stock markets. Utilizing the Paris Agreement and China's President Xi's pledge to achieve carbon neutrality by 2060 as ESG shocks, we find that firms with lower ESG scores provide higher stock returns after the announcement of the Paris Agreement. Furthermore, the effect of ESG performance heightens after Xi's pledge. Using sorted portfolios and Fama–French factor models, we find that investors are rewarded for bearing ESG-related risks. Our estimated monthly ESG risk premium is between 0.52% and 0.61%, while state-owned firms with larger market capitalizations and better financial and operational performance tend to have better ESG performance.     

How financial information disclosure affects risk perception. Evidence from Italian investors’ behaviour

This paper investigates how different representations of financial information may be appraised in terms of complexity and usefulness, and how financial disclosure influences individuals’ risk perception. By using a consumer testing analytical approach, we run a survey on a sample of Italian investors: 254 bank customers were submitted 4 different templates, each combining a different typology of data (historical and prospective) and framing (words, numbers and charts) to indicate the same level of risk and return of four real-life financial instruments. Representation formats partially overlap with those mandated by regulators and used within the financial industry. Results show that the perceived riskiness of financial products is affected by the way information is disclosed. Perceived complexity of the financial information disclosure intensifies perception of riskiness of the product solicited. Gender, age, personal traits, behavioural biases and financial knowledge, do also play a role. Overall, given investors’ heterogeneity and behavioural biases, neither simplifying disclosure nor a ‘one-size-fits-all’ approach may be sufficient to ensure correct risk perception and to prevent unbiased investment choices.     

Transparency,idiosyncratic risk,and convertible bonds

We first investigate the relationship among a company's information transparency, idiosyncratic risk, and return of its convertible bonds. The effects of a company's idiosyncratic risk on its equity's value volatility and its credit risk are also examined. The findings indicate that when a company discloses a significant amount of information, it is likely to have a higher idiosyncratic risk and a lower credit risk, with no impact on returns on convertible bonds. The volatility of stock returns is positively related to returns on convertible bonds, and it is found that diversified strategies and returns on a company's equity help to improve its credit rating and that a better credit rating triggers an increase in returns on convertible bonds and idiosyncratic risk, indicating that evaluations of the value of convertible bonds must take pure bonds and equity (option) values into account. After excluding conversion values and estimating the idiosyncratic risk on daily, weekly, and monthly bases, this study suggests that there is a positive relation between returns on convertible bonds and information transparency when estimating idiosyncratic risk on a monthly basis and that a positive association also exists between credit rating, idiosyncratic risk, and returns on bonds.