Sustainable Investing with ESG Rating Uncertainty

Earlier this year, regulatory bodies such as the Securities and Exchange Commission (SEC) for the US and the European Securities and Markets Authority (ESMA) for the EU launched an extensive consultation about ESG disclosure regulation, i.e., about firms’ environmental, social and governance (ESG) related risks and opportunities. Three phenomena triggered this regulatory activity: i) a considerable growth in the demand for socially responsible vehicles, ii) an impressive disagreement amongst ESG data vendors about the ESG profiles of companies, and iii) visible or latent ESG- and green-washing by companies and asset management firms.

As the ESG objective is becoming a primary focus for all business sectors, the reallocation of capital has major implications for portfolio decisions and asset pricing. However, ESG investors often confront a substantial amount of uncertainty about the true ESG profile of a firm. Without a reliable measure of the true ESG performance, any attempt to quantify it needs to cope with incomplete and opaque ESG data and nonstructured rating methodologies. While such uncertainty could be an important barrier to sustainable investing, to date, little attention has been devoted to the role of ESG uncertainty in portfolio decisions and asset pricing. Our paper Sustainable Investing with ESG Rating Uncertainty (forthcoming in the Journal of Financial Economics) aims to fill this gap.

We consider an economy populated by agents who extract nonpecuniary benefits from holding stocks. The nonpecuniary benefit is directly linked to the ESG profile of the firm. Due to uncertainty about the ESG profile, stocks are perceived to be riskier. Consequently, the demand for equities falls due to ESG uncertainty, even for green firms. While green stocks should have lower expected returns due to the nonpecuniary benefits from holding them, there is an offsetting force in the presence of ESG uncertainty because the higher perceived risk essentially commands a higher premium. The ultimate implications of ESG preferences with uncertainty for the greenium (i.e., the spread between green and brown stocks’ returns) are thus inconclusive. For perspective, previous literature which considers ESG preference but ignores ESG uncertainty documented an increasing demand for risky assets and a negative greenium, i.e., brown stocks always outperform green stocks.

We further derive a CAPM representation where both alpha and the effective beta of the firms vary with firm-level ESG uncertainty. When ESG uncertainty is not accounted for, the CAPM alpha exclusively reflects the willingness to hold green stocks due to nonpecuniary benefits, and the ESG-alpha relation is, hence, negative. Accounting for ESG uncertainty, the equilibrium alpha increases with ESG uncertainty for a given level of average ESG rating, and the ESG-alpha relation weakens. Our theoretical model provides a possible explanation for the well documented mixed evidence in academic as well as professional literature as to the ESG-return relationship.

An empirical investigation tests the main model predictions. We used data on ESG ratings from six major rating agencies. The average (standard deviation of) ESG ratings across rating agencies is our proxy for the firm-level ESG rating (ESG uncertainty). Our study focuses on US stocks exclusively. We find support for three of our model’s implications. We first document that ESG uncertainty reduces the demand for stocks. Norm-constrained institutions such as pension funds as well as university and foundation endowments, display preferences for high ESG firms. In the presence of uncertainty about the ESG profile of companies, these investors lower their demand for the corresponding stocks. For instance, among the high-ESG rating portfolios, norm-constrained institutions hold 22.8% of the low-uncertainty stocks but only 18.1% of the high-uncertainty stocks, indicating a 21% decline. The results are particularly strong among high-ESG stocks, suggesting that rating uncertainty matters the most for ESG-sensitive investors in their ESG investment. In addition, while hedge funds invest more in low-ESG stocks, rating uncertainty plays a similar role in discouraging stock investment. Second, we find that the ESG rating is negatively associated with future performance among stocks with low ESG uncertainty, and the long-short portfolio yields a CAPM-adjusted return of 0.40% per month. However, the negative return predictability of ESG ratings does not hold for the remaining firms. Finally, we calibrate the model for plausible values for relevant parameters. This allows us to quantify the welfare cost of ESG uncertainty which is economically significant.

Our findings echo the growing concerns regarding the lack of consistency of ESG information disclosure and ratings provided by different rating agencies. First, we demonstrate how disagreement amongst ESG data vendors and the ensuing ESG uncertainty impact financial markets. To the extent that the cost of capital is key for real investment in general and the impact investment in particular, ESG uncertainty is harmful to economic growth and the transition to a greener economy: perceived riskiness of equities increases due to ESG uncertainty. Second, it would be useful for policy makers to establish a clear taxonomy of ESG performance and unified disclosure standards for sustainability reporting. It would be especially instructive to identify which investments are really green. Doing so could mitigate ESG uncertainty, thus reducing the cost of equity capital for green firms, leading to higher social impact.

The complete paper is available for download here.