ESG Confusion and Stock Returns: Tackling the Problem of Noise
68 Pages Posted: 12 Oct 2021 Last revised: 7 Oct 2022
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ESG Confusion and Stock Returns: Tackling the Problem of Noise
ESG Confusion and Stock Returns: Tackling the Problem of Noise
Date Written: October 12, 2021
Abstract
How does ESG (environmental, social, and governance) performance affect stock returns? Answering this question is difficult because existing measures of ESG performance — ESG ratings — are noisy and, therefore, standard regression estimates suffer from attenuation bias. To address the bias, we propose two noise-correction procedures, 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: after correcting for attenuation bias, the coefficients increase on average by a factor of 2.6, implying an average noise-to-signal ratio of 61.7%. The attenuation bias is stable across horizons at which stock returns are measured. In simulations, our noise-correction procedures outperform the standard approaches followed by practitioners such as averages or principal component analysis.
Keywords: measurement error, instrumental variables, sustainable investing, ESG ratings
JEL Classification: C26, G12, Q56
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