The value of an investment is no longer just about financial returns. A growing number of investors and other corporate stakeholders are calling for their money to go toward stocks or funds that are both profitable over the long term and reflective of their social values.[1]
In a new paper, “Sustainable Investing: An incentive to do “good” and attract the “right” investors?” we show that companies have strong incentives to do “good” by serving a beneficial purpose and to attract the “right” financially sophisticated and dedicated investors. However, companies’ good practices need to be visible to the market, through outside rating procedures, to reap the benefits.
Our paper poses the question of whether information about a firm’s engagement in environmental, social, and governance (ESG) practices is material to market participants. Our evidence shows that firms for which ESG information is available prior to their going public exhibit greater underpricing of their shares than do peers for which such information is not available. In other words, the market responds more favorably to the former companies
We first ask whether this positive market reaction is based on economic reasoning or on investors’ attitude toward ESG. We determine whether, immediately prior to the IPO, a commitment to ESG was prompted by good management or by agency costs. We show that the commitment was probably prompted by good governance that aligns the firm’s interests with those of society and investors rather than by managers’ self-serving motives.
Second, we ask whether the positive market reaction dissipates shortly after the IPO. We show that, compared with firms that offer no information about their ESG practices, equity issuers for which there was ESG information prior to their going public exhibit significantly higher abnormal returns, raise more new capital with better terms, perform better, and have a higher market value.
Third, we ask who holds stocks of companies with favorably rated ESG performance. We examine what proportion of the shareholders are institutions and analyze shareholders’ profiles using Bushee’s (1998, 2001) classification. We document that a large share of the stock of issuers with favorable ESG ratings is held by long-term oriented shareholders that are well-informed, monitor managerial investment, and, therefore, are not misled in their assessment of how much valued ESG creates.
Our findings confirm that a commitment to ESG results from good management and is rewarded by the market. Investors interested in ESG scrutinize a company’s ESG profile before investing. What’s more, market scrutiny pushes firms to maintain sustainable practices to ensure their further success. Our results rule out the possibility of affection-driven bias (i.e., investors mistakenly attributing more value to companies with strong commitments to ESG, resulting in a more favorable stock-price reaction to those companies’ IPOs) and later disappointment.
An important implication of our results is that it behooves firms to consider their ESG profiles and aim for good ratings in managing their ESG risks. Companies have a strong incentive to be socially responsible, but it is also important that they be seen to be socially responsible by prominently disclosing their ESG ratings to investors and stakeholders. Further, for companies that see the value in having shareholders focused on the long term, a transparent rating of ESG performance is an effective way to attract those investors. Finally, particularly in United States, stricter regulations about mandatory ESG disclosure would be an important step towards benefiting not only firms and shareholders but also stakeholders.
ENDNOTE
[1] Report on US Sustainable and Impact Investing Trends, The US Sustainable Investment Foundation (SIF) Biennial Report. Washington D.C. November 2020.
This post comes to us from Professor Claire Economidou at the University of Piraeus; Professor Dimitrios Gounopoulos at the University of Bath; Dimitris Konstantios, a post-doctoral researcher at the University of Piraeus; and Professor Emmanuel D. Tsiritakis at the University of Piraeus. It is based on their recent paper, “Sustainable Investing: An incentive for firms to do ‘good’ and attract the ‘right’ investors?” available here.