ESG Confusion and Stock Returns: Tackling the Problem of Noise

68 Pages Posted: 12 Oct 2021 Last revised: 7 Oct 2022

See all articles by Florian Berg

Florian Berg

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

Julian F Kölbel

University of St. Gallen - School of Finance; MIT Sloan; Swiss Finance Institute

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)

Multiple version iconThere are 2 versions of this paper

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

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 St. Gallen - School of Finance ( email )

Unterer Graben 21
St. Gallen, 9000
Switzerland

MIT Sloan ( email )

100 Main Street
Cambridge, MA 02142
United States

Swiss Finance Institute ( email )

c/o University of Geneva
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CH-1211 Geneva 4
Switzerland

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 )

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Cambridge, MA 02138
United States

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