Corporations increasingly integrate environmental, social, and governance (ESG) issues into their business practices and signal this by committing to sustainability initiatives, such as the UN Global Compact or the 2019 Business Roundtable Statement on the Purpose of a Corporation. This development has spurred a debate on whether companies can become more profitable by creating societal value (e.g., Edmans 2020), but there is relatively little discussion of companies that have been involved repeatedly in ESG-related incidents. For example, before its Deepwater Horizon oil spill in 2010, BP had a long history of major and minor environmental and safety incidents. Between 2007 and 2009, those incidents include the Texas City refinery explosion, pipeline leaks in Alaska, attempts to manipulate the propane market, and frequent safety violations (e.g., Cherry and Sneirson 2011). The case of BP illustrates that firms may fall short of their sustainable commitments and save money at the expense of their stakeholders, which in the extreme may lead to both sizable losses and disastrous societal outcomes.
In my new paper, ESG Incidents and Shareholder Value, I use a novel dataset of negative news about incidents to study poor ESG practices. I examine the following questions: Is a firm’s incident history predictive of future ESG incidents? How do high incident rates affect firm value over time? Do stock markets properly price incident-based ESG information? If not, what prevents investors from doing so? The answers to these questions help us to understand why some firms have higher incident rates and thus are important not only for corporate managers but also for investors and policymakers who attempt to curb negative externalities on stakeholders.
From a theoretical perspective, it is unclear whether poor ESG practices would increase or decrease shareholder value. On the one hand, companies may maximize shareholder value by spending less on their stakeholders’ needs or on protecting the environment. High ESG incident rates would then imply a strong shareholder focus and high cost-efficiency. On the other hand, poor ESG practices may be the result of managerial short-termism (Bénabou and Tirole 2010). While ignoring ESG policies and practices can increase profits over the short term, it may lower long-term value through a higher probability of new ESG incidents, reputational damage, and less social capital and trust.
The empirical innovation of my paper is to measure poor ESG practices by a firm’s ESG incident history. I study the value implications of a firm’s past ESG incident rate, which reflects the frequency and severity of past ESG incidents (e.g., environmental pollution, poor employment conditions, or anti-competitive practices). I obtained the incident data from RepRisk, which collected over 80,000 news reports about incidents involving publicly listed U.S, firms between 2007 and 2017.
The key advantage of incident-based ESG measures over conventional ESG ratings (e.g., MSCI IVA or ASSET4) is that an incident measure directly captures poor ESG practices, through ESG-related business risks that materialize and stakeholder criticism. An incident measure could therefore be a better predictor of future incidents than conventional ESG ratings. The problem with conventional ESG ratings is that it is unclear what they measure. Conventional ratings aggregate hundreds of ESG criteria into one company score using very different approaches. As a result, these ratings often disagree with each other, which raises concerns about their validity (e.g. Chatterji et al. 2016).
Studying the value implications of a firm’s incident history, I find five key results:
Past ESG incident rates predict more future incidents and lower operating profits. These results suggest that poor ESG practices negatively affect firm performance through a higher probability of new incidents. Consistent with this interpretation, I find that stock markets react negatively to news of a company’s ESG incident (which suggests that ESG incidents destroy firm value).
Past ESG incident rates are associated with higher disagreement among conventional ESG ratings. This result suggests that ESG rating providers (including MSCI IVA, ASSET4, etc.) disagree more on how sustainable a company is when it has had more incidents in the past. Put differently, not every rating provider gives a company with a history of incidents a lower ESG rating. This rating disagreement makes it more difficult for investors to identify and value companies with poor ESG practices.
Past ESG incident rates predict negative stock returns. A value-weighted U.S. portfolio with high ESG incident rates underperforms the stock markets by about -3.5 percent per year. This result is robust to risk factors, industries, outliers, alternative specifications, and other robustness checks. Moreover, I find that a European portfolio with high ESG incident rates also underperforms by -2.5 percent per year.
Past ESG incident rates predict negative analyst forecast errors as well as lower stock returns when companies announce their earnings or have new ESG incidents. These results suggest that sell-side analysts and investors overestimate the earnings and underestimate the probability of new incidents associated with firms with high ESG incident rates. These two sources of investor surprises (lower earnings and more subsequent incidents than expected) can explain about three-fifths of the lower stock returns of firms with high ESG incident rates. This evidence suggests that stock markets are surprised by the negative value implications of poor ESG practices.
Past ESG incident rates predict more negative stock returns in firms that have more short-term oriented investors, are more difficult to value, or receive less investor attention. These results suggest that investors – especially those with short horizons – do not pay enough attention to a firm’s ESG-incident history. Additional tests show that short-term investors are unable to predict when a company will have more incidents. These findings are consistent with behavioral finance theory arguing that investors absorb salient, easily processable information to a higher degree than non-salient information. Investors may find it difficult to value poor ESG practices due to ESG rating disagreement, the need to separate material from immaterial ESG information, the long-term nature of ESG, lack of standardized ESG reporting, and potential “greenwashing” activities by corporations.
Overall, my findings suggest that poor ESG practices negatively affect long-term value, which is not fully reflected in stock prices. Stock market participants do not pay enough attention to a firm’s incident history, which leads to predictable negative stock returns when the poor ESG practices result in lower earnings or new ESG incidents. This stock underreaction appears to be driven by short-term investors that neglect incident-based ESG information in their investment decisions.
From a corporate perspective, these findings emphasize the long-term costs of poor ESG practices and suggest that short-term-oriented market participants underreact to these value implications. The market underreaction results in overvalued stock and overly optimistic earnings forecasts for firms with high ESG incident rates, which in turn may explain why these firms ignore ESG practices. Taken together, my evidence suggests that, while poor ESG practices can boost stock prices over the short term, they negatively affect long-term value through a higher probability of future incidents.
From an investor perspective, my findings highlight the materiality of incident-based ESG information and call for increased attention to a firm’s history of ESG incidents. Furthermore, excluding firms with high ESG incident rates from a portfolio may result in a better investment performance if a sufficient fraction of investors continues to neglect incident-based ESG information.
One caveat remains: There are also non-causal explanations for my findings. The correlation between poor ESG practices and future stock performance could be driven by an unobserved third variable. Alternatively, causality could go in the opposite direction, meaning that companies that predict lower future stock performance reduce spending on ESG today. Although I conduct several empirical tests to make my results as robust as possible against these non-causal explanations, I cannot rule them out completely.
Bénabou, Roland and Jean Tirole (2010). “Individual and corporate social responsibility.” Economica 77.305, 1–19.
Chatterji, Aaron K, Rodolphe Durand, David I Levine, and Samuel Touboul (2016). “Do ratings of firms converge? Implications for managers, investors, and strategy researchers.” Strategic Management Journal 37.8, 1597–1614.
Cherry, Miriam A and Judd F Sneirson (2011). “Beyond profit: Rethinking corporate social responsibility and greenwashing after the BP oil disaster.” Tulane Law Review 85.4, 983–1038.
Edmans, Alex (2020). “Grow the pie: How great companies deliver both purpose and profit.” Cambridge University Press.
This post comes to us from Simon Glossner at the University of Virginia’s Darden School of Business and the Richard A. Mayo Center for Asset Management. It is based on his recent article, “ESG Incidents and Shareholder Value,” available here.