"Stock Price Reactions to ESG News: the Role of ESG Ratings and Disagreement"
Updated: Oct 7, 2022
"Stock price reactions to ESG news: the role of ESG ratings and disagreement," written by George Serafeim and Aaron Yoon, was published in Review of Accounting Studies in 2022. The paper investigates whether ESG ratings predict future ESG news and stock returns and how the raters' disagreement affects such predictive ability. The paper provides several hypotheses to examine the relationship between ESG ratings and news.
In recent years, ESG practices have been a fast-growing phenomenon and the subject of attention for firms; regulators have placed an increasing emphasis on understanding how ESG information flows into the market and how capital market participants react to such information. Various rating institutions produce aggregate ESG ratings using different metrics and weights, generating significant divergence in ESG rating systems. Therefore, Hypothesis 1: There is a positive relationship between ESG ratings and more positive future ESG news.
As rater divergence will moderate the relationship between ratings and news, such disagreement will make ratings less likely to predict future news accurately. Therefore, Hypothesis 2: The relationship between ESG ratings and more positive future ESG news will be negatively moderated by the level of rater disagreement.
As firms in the news are more likely to capture investors' attention than firms that are not, such investor attention affects stock returns. Better ESG performance translates into value because of operating efficiency, stronger brand and customer loyalty, and employee engagement. However, a rise in the firm's cost associated with ESG efforts will serve as a disadvantage in a competitive market, leading to adverse market reactions to positive ESG news. Therefore, Hypothesis 3: More positive ESG news will be associated with more positive stock price reactions to the news.
As the consensus ESG rating will moderate the relationship between news and stock price reactions, ESG ratings may shape market expectations regarding future ESG news and affect the associated market reaction. Specifically, firms with low consensus ESG ratings will react more strongly to positive news than firms with high consensus ESG ratings. Negative news will likely generate a negative market reaction regardless of firms' ESG ratings. Therefore, Hypothesis 4: For positive ESG news, the relationship between ESG news and stock price reactions will be negatively moderated by ESG ratings.
High-rater divergence will weaken the relationship between ratings and news, as investors will be confused when interpreting the news. Such disagreement will likely mitigate the role of ESG ratings, as the consensus rating is less likely to be a meaningful measure of investors' expectations. Markets confused about a firm's ESG prospects could lead to a decrease in the predictive ability of ESG ratings. Therefore, Hypothesis 5: The positive relationship between ESG news and stock price reactions and the moderating role of ESG ratings will be weakened by rater disagreement.
A low correlation among ESG ratings from different agencies reflects that most ESG reporting agencies exercise subjective discretion in interpreting firms' ESG-related disclosures. Therefore, Hypothesis 6: Different rates will exhibit the differential predictive ability of future ESG news.
With the differential predictive ability and the nascent field of ESG investing, market participants do not fully incorporate such predictive ability in prices. Therefore, Hypothesis 7: The differential predictive ability concerning future ESG news is only gradually incorporated into market prices.
The paper produces several findings.
1. Consensus ESG rating predicts future ESG news, but the extent of rater disagreement moderates this relationship.
2. There is a positive market reaction to positive ESG news and a negative market reaction to negative news. Interestingly, the market reaction to positive news is smaller for firms with high ESG ratings, which implies that positive news is already being reflected in stock prices.
3. ESG ratings from different providers have differential predictive ability, and the rating provided by the most predictive power predicts future stock returns in the presence of high rating disagreement.