CEOs and institutional investors have increasingly embraced Environmental, Social, and Governance (ESG) considerations and used them in deciding where to invest. According to the Sustainable Investment Forum, the value of U.S. sustainable assets rose from $6.6 trillion in 2014 to an impressive $17.1 trillion in 2020. This surge is part of a global trend: The Global Sustainable Investment Alliance (GSIA) estimates that sustainable asset values in the U.S., Europe, Canada, Australia, and Japan increased to $35.3 trillion in 2020 from $22.8 trillion in 2016.

Investors in firms that emphasize ESG qualities appear to greatly reduce risk and earn returns that exceed those of conventional investments (Derwall et al., 2005; Kempf and Osthoff, 2007). According to a comprehensive McKinsey study conducted by Henisz et al. (2019), for example, strong ESG performance correlates positively with higher equity returns and a reduction in downside risk. However, recent evidence also raises doubts about firms that embrace ESG. Hartzmark and Sussman (2019) and Döttling and Kim (2022), for example, find that investors might prioritize sustainability over performance, leading them to be more dedicated to funds aligning with these values in their mandates.

In a new paper, we address the impact of ESG ratings on a firm’s financial performance by studying how those ratings affect the cost of equity (COE). Specifically, we evaluate the direction and magnitude of the relationship between ESG ratings and the COE for U.S. public firms. Then, we focus on factors that could affect the relationship, such as firm size, whether the firm’s stock is included in a major index (e.g., S&P 500), and the firm’s energy needs (i.e., energy intensity classification)

We first measure COE using an implied COE estimate that relies on residual income and dividend-discounting valuation models. Unlike the traditional factor models (e.g., CAPM), this measure is forward looking and exploits analysts’ earnings forecasts as proxies for the market’s expectation of future earnings.

The results of our analysis from 2004 to 2022 reveal that a firm’s COE increases on average 15 basis points with a one standard-deviation increase in the ESG rating. This relationship is predominantly observed among S&P 500 firms and other large firms. Additionally, we find that energy-intensive firms’ COE is influenced less by a high ESG rating.

We interpret the relationship between ESG ratings and COE through three key factors. First, long-term financial-performance expectations are crucial. Companies that invest in ESG initiatives and disclose them to improve their ESG rating incur additional costs that investors expect to be compensated for. Consequently, this leads to higher returns and an increased COE for the firm. Second, ESG practices could lead to perceptions of increased risk. While a high ESG rating reduces exposure to long-term ESG risks, the impact varies, depending on the firm and industry. Embracing sustainable practices may introduce new risks, such as regulatory changes, lawsuits, or reputational issues. To account for these potential risks, investors may demand higher returns and a higher COE. Last, evolution in the ESG market and concerns about greenwashing contribute to the relationship. As the ESG market matures, investors give closer scrutiny to potential sustainable investments. If investors perceive a firm’s ESG efforts as greenwashing, their interest in investing decreases, which can result in a higher COE. The Securities and Exchange Commission (SEC) has responded to these concerns by proposed cracking down on greenwashing with stricter standards and disclosure requirements for ESG funds.

Our paper offers valuable insights for investors and firms seeking sustainable investments. Our findings challenge the widely held belief that higher ESG ratings always lead to a reduction in the cost of equity financing. While firms with higher ESG ratings may benefit from attracting socially responsible investors and ESG-focused funds, they must also navigate increased scrutiny and potential risks associated with sustainable practices.

Investors should consider a variety of factors before making ESG investments, including industry-specific dynamics, firm-level characteristics, and the broader investment climate. The influence of a firm’s ESG rating on its COE varies across different segments of the market, such as S&P 500 firms and low energy-intensity firms. Consequently, a one-size-fits-all approach to sustainable investing may not yield optimal results.

For firms, it is important to understand that a high ESG rating may not always result in reduced COE. By adopting a comprehensive approach to sustainable practices and considering industry-specific risks, firms can effectively attract ESG-conscious investors while managing their COE.

RESOURCES

Derwall, J., N. Guenster, R. Bauer, and K. Koedijk (2005). The eco-efficiency premium puzzle. Financial Analysts Journal 61 (2), 51–63.

Döttling, R., and S. Kim (2022). Sustainability preferences under stress: Evidence from COVID-19. Journal of Financial and Quantitative Analysis 1-39. doi:10.1017/S0022109022001296

Hartzmark, S. M. and A. B. Sussman (2019). Do investors value sustainability? a natural experiment examining ranking and fund flows. The Journal of Finance 74 (6), 2789–2837.

Henisz, W., T. Koller, and R. Nuttall (2019). Five ways that ESG creates value. McKinsey & Company: New York, NY, USA.

Kempf, A. and P. Osthoff (2007). The effect of socially responsible investing on portfolio performance. EuropeanFinancial Management 13 (5), 908–922.

This post comes to us from Alessio Galluzzi and Reuben Segara at the University of Sydney Business School and Fergus O’Donnell at Azure Capital. It is based on their recent article, “The Cost of Being Green: How ESG Ratings Affect a Firm’s Cost of Equity,” available here.