ESG Confusion and Stock Returns: Tackling the Problem of Noise

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.