When ESG was relatively new, investors looked to it as a way to chase alpha. However, now the peak of the ESG hype has passed. Academics and economists are skeptical about the link between ESG performance and stock price. Investors appear less willing to pay a premium for strong ESG programs than they were several years ago. However, there is evidence that investors still care about ESG, especially in companies that display sub-par performance. A new study finds investors are particularly critical of poor ESG performance among large companies:
“The empirical results show that ESG downgrades are followed by economically meaningful negative cumulative abnormal returns, whereas upgrades generate only weak and short-lived effects. In addition, the pricing response is not conditioned equally by all sentiment dimensions. Positive sentiment is found to be the most important moderating channel. We show that the negative valuation effect of ESG downgrades is significantly stronger in a more optimistic surrounding informational environment, while the other sentiment dimensions play relatively limited roles. Our result is especially pronounced for large firms and for firms with strong pre-event ESG profiles, both of which are likely to attract greater investor attention and to be held more widely by institutional and ESG-oriented investors.”
These results indicate that investors increasingly view ESG as an essential business function. That unfortunately means firms score fewer points with investors for good ESG performance than they lose for poor ESG performance. Greenwashing may also play a role in this dynamic. Investors are more skeptical of ESG claims that paint companies in a positive light. We’ve all learned to take sustainability claims with a grain of salt after being burned on multiple occasions. On the other hand, when a company is downgraded, investors know the downgrade is based on reliable information, giving the negative impact of downgrades more weight. Ultimately, investors use sticks rather than carrots to incentivize companies to pursue ESG. This is unfortunate, because the study also indicates that companies find positive investor sentiment more persuasive.
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