CLS Blue Sky Blog

Do Investor Reactions Differ Across the Lifecycle of ESG Initiatives?

Firms often take on environmental, social, and governance (ESG) initiatives to increase their sustainability and the positive feelings among investors. However, specific ESG initiatives, like all business initiatives, rarely continue indefinitely, and “pruning” them is an integral part of firms’ strategic approach to ESG. Firms may discontinue even successful ESG initiatives, perhaps because of financial strain or uncertainty from developments like the COVID-19 pandemic. In a recent paper, we investigate how investors’ reactions to ESG might change over the lifecycle of an ESG initiative. Specifically, we test the idea that investors are most sensitive to the ethical implications of ESG when firms decide to discontinue ESG initiatives compared with when they start or continue the initiatives. This “ESG stopping effect” means that even if investors react similarly to the launch of new ESG and other types of business initiatives, they will react more negatively to the discontinuation of ESG initiatives than they would to discontinuation of other initiatives.

We base this prediction on theory developed in psychology, consumer behavior, and economics. This theory suggests that individuals, like consumers or employees, react particularly negatively to giving up items that have an ethical or moral dimension. Interestingly, this negative reaction occurs even when the desire to attain these items is not especially great. In other words, at least in non-investing settings, ethical considerations do not lead to an overall increase in the value individuals place on an item. Rather, people are particularly sensitive to the ethical nature of items when they consider giving them up. Because ESG initiatives usually have strong ethical implications for investors, this theory may also apply to the stopping of ESG initiatives.

In an investing setting, ethical considerations frequently conflict with financial considerations that are uniquely important to investors. That is, if an initiative – whether or not it is related to ESG – is financially costly for a firm overall, then ending that initiative would represent a financial benefit. However, the insights from psychology, consumer behavior, and economics noted above imply that if the initiative has ethical implications, then investors will likely also perceive ethical costs that would offset the financial benefit of stopping the initiative.

We examine these ideas in two experiments where some investors are told about a company that is starting an initiative, and others are told about a company that is stopping an initiative. We vary how we describe the initiative that is being started or stopped. In the first experiment, some investors learn that the company’s packaging initiative represents a general business activity – the adoption of packaging that is easier to open – while others learn that the initiative is an environmentally-focused ESG initiative – the increased use of environmentally friendly packaging materials. In the second experiment, we compare the environmentally friendly packaging initiative used in the first experiment with an ESG initiative that is designed to convey an even more pronounced ethical consideration – the use of low-phthalate materials that have been linked to a reduced risk of cancer and other health issues.

Consistent with our predictions, in both experiments we find that investors react more negatively to the firm’s decision to stop the initiative with larger ethical implications, despite no significant difference in reactions to starting the initiatives. In other words, we show a significant ESG stopping effect that is especially sensitive to ethical considerations.

In a third experiment, we examine two factors that might reduce the ESG stopping effect: ESG effectiveness and a financial justification for ending an initiative. These factors are important to consider because there has recently been immense growth in the amount of information about firms’ ESG activities that is available to investors, yet there are not currently authoritative standards for what firms must report. In this third experiment, investors learn whether the same environmentally friendly packaging initiative that we utilized in the other two experiments has been relatively more or less effective than expected in reducing the firm’s carbon footprint. Next, investors learn that the firm has decided to end the initiative, with some investors also being specifically told that the reason for stopping the initiative is that the related financial costs outweigh the financial benefits. Results indicate that investors react more negatively to the discontinuation of the more effective initiative. However, providing investors with a financial justification for ending ESG partially attenuates their more pronounced negative reaction to ending the more effective initiative. Nevertheless, even in the presence of a salient financial justification, we continue to find a significant ESG stopping effect. Investors continue to place significant weight on ethical considerations related to ending ESG, even when there is a financial justification for ending the initiative.

Our research implies that investors’ reactions to firms’ ESG activities are likely to differ across the lifecycle of a specific ESG initiative. On a practical level, this insight suggests that for firms to make informed decisions, they should consider all stages of ESG initiatives’ lifecycle, including the potential for a markedly negative ESG stopping effect. Given that ESG initiatives rarely have indefinite lives, the potentially large negative consequences of ending those initiatives adds a crucial new factor relevant to managerial decision-making.

From a disclosure standpoint, our findings suggest firms might not want to highlight the success of an initiative when announcing its end. It is likely counterintuitive for firms that announcing what is ostensibly good news regarding ESG performance – i.e., an initiative was as successful or more successful than planned – instead amplifies investors’ negative reaction to ending the initiative and amplifies the ESG stopping effect. Our finding that investors appear sympathetic to financial justifications for ending relatively effective ESG initiatives suggests that firms can sometimes soften the blow of ending ESG through transparent disclosures. However,  our results suggest such financial considerations are unlikely to fully offset investors’ negative reactions.

These insights may prove helpful for financial markets regulators and reporting-standards setters. We provide new evidence regarding the information that investors care about in the ESG setting, where efforts to create authoritative guidance are already underway. Our findings imply that investors utilize, and are therefore likely to demand, information about firms’ discontinuing ESG initiatives, the underlying effectiveness of those ESG initiatives, and firms’ rationale for stopping ESG initiatives. Regulators considering new standards related to ESG reporting may need to prioritize ensuring adequate disclosures around these specific ESG-related events.

This post comes to us from professors Shannon Garavaglia at the University of Pittsburgh, Ben W. Van Landuyt at the University of Arizona, and Brian J. White and Julie R. Irwin at the University of Texas’ McCombs School of Business. It is based on their recent article, “The ESG Stopping Effect: Do Investor Reactions Differ Across the Lifecycle of ESG Initiatives?” available here.

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