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2. Literature Review
ESG issue has become popular in academic field in recent years. Literatures about ESG in corporate finance, investing, behavior finance and management allow us to build our knowledge about ESG issue. The puzzles of ESG have been resolved greatly.
Attig et al. (2016) shed light on ESG firm characteristics. They find that the degree of internalization of a firm is positively correlated with its ESG rating. As for the benefits of ESG, many studies mention that ESG investments not only bring benefits to the society, but also the enterprises. Albuquerque et al. (2018) assume that CSR investments can bring product differentiation effect. Based on the assumption, they believe that firms with higher CSR scores will have lower systematic risk, higher firm value and smoother profits. The empirical evidence supports their prediction. Friede et al. (2015) gather more than 2000 empirical studies and analyze with vote-count studies and meta-analyses. They find a positive and stable ESG impact on corporate financial performance.
There are studies that examine whether ESG score can impact firm value. El Ghoul et al. (2017) find that when the “institutional voids” is more serious in the market, CSR activities benefits more on firm value and external growth. In a risk management perspective, the use of currency derivatives for well-governed firms is associated with a significant value premium because well-governed firms tend to use derivatives to hedge currency exposure, rather than managerial reasons (Allayannis et al. 2012).
Fatemi et al. (2018) conclude that ESG strength is increasing firm value while ESG concern is damaging firm value. Besides, there is a moderating effect of ESG disclosure on firm valuation. They argue that ESG disclosure can mitigate negative influence that ESG concerns bring because ESG disclosure send positive ESG commitments to investors. On the other hand, ESG disclosure can mitigate positive influence that ESG strengths bring because investors will interpret disclosures as firms trying to convince
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the markets an overinvestment on ESG. However, the conclusion is different from prior papers.
2.1 ESG and Risk
As mentioned above, ESG engagement is beneficial to enterprises. I assume that one of the most important benefits ESG brings is reducing risk. Benlemlih et al. (2018) find a significant negative relationship between a firm’s E and S disclosure score and its total and residual risk. The findings support the claim that extensive E and G disclosure can enhance corporate transparency. By eliminating information asymmetry problem, firms can build positive reputation among stakeholders. There are evidence that ESG engagement also helps to reduce risk in controversy industries (Jo and Na 2012). The results reflect that firms in controversial industries engage in CSR for risk reducing, instead of window dressing. Other studies focus on the impact of different CSR aspects on risk. Oikonomou et al. (2012) present two main findings. First, CSR aggregated components can better capture corporate social performance (CSP) effect on market risk than individual components (diversity, environment, community etc.) Second, during financial distress, socially irresponsible firms which has more CSP concerns will face more serious stock price volatility. On the other hand, when the market fluctuation is comparably small, CSR strengths can lead the firms to lower stock price volatility.
2.2 ESG and Downside risk
The ESG score has much to do with downside risk. In a strategic view, Husted (2005) believes CSR investments can be seen as a real option to control ex ante risks because it limits a firm’s downside outcomes. Godfrey (2005) argues that ESG engagement of firms can generate moral capital, which has an insurance-like protection
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function. It protects shareholder relational wealth because of good trust and reputation among stakeholders. Thus, moral capital mitigates the loss of shareholder value when bad news happens. In this paper, downside risk is further presented in the form of stock price crash risk and financial constraints respectively.
2.3 ESG and Stock Price Crash Risk
Hoepner et al. (2018) find that large institutional investors’ engagement in ESG issue can lower firms’ downside risk. The downside risk is measured by LPM (0,2), LPM (0,3) and VaR. Compared to matched firms, Lower partial moments of the second (third) order are 1.2% (1.4%) lower at firms engage in ESG, which is economically significant. However, the downside risk effect is only in governance and environment aspect. They do not find downside risk effect in social aspect. Hutton et al. (2009) present that financial transparency such as decreasing earning management can lower crash risk. Kim et al. (2014) show that a firm’s CSR performance is negatively associated with future crash risk because of higher standard of transparency and less bad news hoarding. With further examination, they argue that the mitigating effect of CSR on crash risk is especially important when governance mechanisms, including monitoring by boards and institutional investors, could not function desirably. There are different opinions about the impact of CSR on crash risk. Becchetti et al. (2015) find that CSR is positively correlated with idiosyncratic volatility. They claim that CSR engagement firms attract specific (smaller) investor population, and thus become less flexible to shocks.
2.4 ESG and Financial Constraint
Many studies explore the impact of ESG engagement on firms’ financial access.
Cheng et al. (2014) find a negative relationship between CSR performance and capital
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constraints. They give two reasons. First, they believe that superior CSR performance can enhance stakeholders’ engagement and thus lower agency costs. Second, firms with better CSR performance tend to be more transparent and thus reduce information asymmetry problems. These all contribute to better access to finance. El Ghoul et al.
(2011) conclude that higher ESG score and cost of equity are negatively correlated. It implies firms with higher ESG score face lower capital constraints. Besides, there are other studies researching whether a firm’s financial access influence its CSR activities, such as Hong et al. (2012) and Chan et al. (2016). By applying current-year, three-year, and five-year averages financial constraint proxies, Chan et al. find that when firms are in financial distress, firms tend to not engage in CSR activities. There is a negative relationship between CSR activities and financial distress. This phenomenon is especially significant when the financial constraint is assessed by the KZ index.
2.5 ESG and Stock Return
Renneboog et al. (2008) review prior research of SRI studies. They conclude that SRI funds do not outperform non-SRI funds. However, SRI investors are still willing to invest in CSR company because they can gain non-financial utility which compensate for lower stock return. Rather than stock return of SRI fund, Brammer et al. (2006) focus on firm level because they argue that fund performance is affected by fund manager’s stock picking ability. With disaggregate measures, they conclude that CSR score is negatively correlated to stock returns. Makni et al. (2009) also find a significant negative relationship between environment score and stock returns in Canadian market. They argue two reasons for the result. First, compared to US market, Canadian market is too small to be a desirable market for environmental investment.
Second, their analysis period is only 2004-2005 and the long-term relationship should be further examined.
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Building on the literature on ESG, I believe that ESG can influence firm risks.
However, there are still many questions to be solved. In this study, I try to clarify the relationship between ESG and different risk measures, and the relationship between ESG and return through the role of risk.