No Smoke and Mirrors Here: Good ESG Ratings Help Stock Prices, Bad Grades Hurt Them

In the culture wars’ latest front, how sustainable principles affect equities is a burning topic addressed in a recent research study.

 

 


OK, who is correct about the performance of ESG investing? The answer, according to a new academic study, won’t cheer GOP Florida Governor Ron DeSantis.

In today’s U.S. culture wars, Republican-led states are seeking to root out environmental, social and governance investing by forbidding pensions and other funds they control from following ESG precepts to be considered. To them, a wifty, tree-hugging approach leads to inferior returns. As a prominent example, Florida has issued multiple bans since August 2022 on public funds considering ESG factors as investment criteria, including a January 17 policy change at the $220 billion Florida Retirement System Pension Plan and this week’s directive to the $5.1 billion Florida Deferred Compensation plan.

Their opponents say the opposite is true: An ESG lens on stock-issuing businesses is needed for the planet’s sake and for the long-term viability of these companies—which will crash and burn, along with their stocks, if green-oriented ideals are not followed.

A new scholarly paper sided with the pro-ESG crowd, stating that stock prices in companies with ESG ratings upgrades rise a maximum of 2.6% over almost two years, while those with downgrades fall a maximum of 3.8% over roughly the same period.

The paper, titled “The Economic Impact of ESG Ratings,” drew on MSCI’s ESG ratings to grade these impacts on market behavior. The MSCI gauge rates companies on their sustainability. It is one of several available, including ratings from ISS ESG, which, like CIO, is owned by Institutional Shareholder Services Inc.

The working paper was published in December 2022 by Florian Berg, a research scientist at the Massachusetts Institute of Technology; Florian Heeb, a researcher at the University of St. Gallen in Switzerland; and Julian Kölbel, an economist at the Swiss Finance Institute.

Over longer timespans, the downgrades have a more powerful corrosive effect on stock performance than the upgrades have on boosting returns, the paper declared.  “We find a negative long-term response of stock returns to downgrades, and a slower and weaker positive response to upgrades,” the report said.

Other evidence shows the difference is not as stark, although it does not support the DeSantis contention that sustainable strategies are big losers. An ESG index from research firm Morningstar shows that sustainable stocks—the index has a large concentration of tech and financial names—do about as well as the broad market.

They hardly blow away the market, but they don’t trail it, either. In battered 2022, the Morningstar index dropped 18.9%, while the S&P 500 was only slightly worse off, falling 19.4%. Over 10 years, the Morningstar shares have an annual average increase of 12.1%, and the S&P 500 comes in at 12.4%.

Do companies heed their ESG grades? Only to a limited extend, the paper concluded: “We find that firms adjust their ESG practices following rating changes, but only in the governance dimension.”

Plus, there is no significant effect of up- or downgrades on capital spending, the report contended.

How wide-ranging the effects of ESG ratings are beyond the investing field is a different story. After all, as many Wall Street experts have observed for years, the stock market may follow the economy, but it is the not the whole economy—merely a piece of it.

The paper concluded that “ESG rating changes matter in financial markets, but so far have only a limited impact on the real economy.”

 

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