ESG Confusion and Stock Returns: Tackling the Problem of Noise

60 Pages Posted: 12 Oct 2021

See all articles by Florian Berg

Florian Berg

Massachusetts Institute of Technology (MIT) - Sloan School of Management

Julian F Kölbel

University of Zurich, Department of Banking and Finance; MIT Sloan

Anna Pavlova

London Business School; Centre for Economic Policy Research (CEPR)

Roberto Rigobon

Massachusetts Institute of Technology (MIT) - Sloan School of Management; National Bureau of Economic Research (NBER)

Date Written: October 12, 2021

Abstract

How strongly does ESG (environmental, social and governance) performance affect stock returns? Answering this question is difficult because existing measures of performance, ESG ratings, are noisy. To tackle the bias, we propose a noise-correction procedure, in which we instrument ESG ratings with ratings of other ESG rating agencies, as in the classical errors-in-variables problem. The corrected estimates demonstrate that the effect of ESG performance on stock returns is stronger than previously estimated; the standard regression estimates of ESG ratings' impact on stock returns are biased downward by about 60%. Our dataset includes scores of eight ESG rating agencies for firms located in North America, Europe, and Japan. We determine which agencies’ scores are valid instruments (not all of them are) and estimate the noise-to-signal ratio for each ESG rating agency (some of which are very large). Overall, our results suggest that it is advantageous to rely on several complementary ratings. In our sample, stocks with higher ESG performance have higher expected returns. Our model provides several explanations for this finding.

Keywords: ESG, errors-in-variables, attenuation bias, ratings, stock returns, noise

JEL Classification: C26, G12

Suggested Citation

Berg, Florian and Kölbel, Julian and Pavlova, Anna and Rigobon, Roberto, ESG Confusion and Stock Returns: Tackling the Problem of Noise (October 12, 2021). Available at SSRN: https://ssrn.com/abstract=3941514 or http://dx.doi.org/10.2139/ssrn.3941514

Florian Berg

Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )

100 Main Street
Cambridge, MA 02142
United States

Julian Kölbel

University of Zurich, Department of Banking and Finance

Schönberggasse 1
Zurich
Switzerland

MIT Sloan ( email )

100 Main Street
Cambridge, MA 02142
United States

Anna Pavlova (Contact Author)

London Business School ( email )

Sussex Place
Regent's Park
London, London NW1 4SA
United Kingdom
+44 20 7000 8218 (Phone)

HOME PAGE: http://faculty.london.edu/apavlova

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Roberto Rigobon

Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )

E52-447
Cambridge, MA 02142
United States
617-258-8374 (Phone)
617-258-6855 (Fax)

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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