Sustainable investing has increased substantially over the past several decades. While ESG investing has grown at unprecedented rates, ESG-oriented funds have recently faced increased scrutiny for marketing sustainability-focused investing strategies but not “following through” on ESG investing promises (e.g., Kim and Yoon 2022; Raghunandan and Rajgopal 2022; SEC 2022). However, selecting and monitoring portfolio firms’ ESG activities is not simple. For example, fund managers likely struggle to monitor portfolio firms due to inherent uncertainty and horizon issues surrounding linking inputs (e.g., investments in green energy) to measurable outputs (e.g., reductions in environmental impact).
To simplify the task of selecting firms based on their ability to acknowledge and manage evolving environmental issues, ESG fund managers likely rely on firms’ ESG ratings. However, recent research suggests that reliance on firms’ ESG ratings may not be sufficient. Our recent paper examines these complex investing decisions from the ESG funds’ perspective. To the extent that fund managers attempt to “walk the talk” by monitoring firms’ ESG performance, we expect fund managers to rely on firms’ ESG ratings and companies’ narrative environmental disclosures to evaluate potential portfolio firms.
It is not evident that ESG fund managers will consider firms’ ESG disclosures (and environmental disclosures specifically) beyond the information summarized in firms’ ESG ratings. For example, regulators’ criticisms may be substantiated, and ESG funds may exclusively rely on ESG ratings to evaluate ESG performance or ignore ESG performance altogether. Moreover, ESG fund managers may continue to struggle to evaluate a company’s environmental performance if the company’s position on environmental issues is vague or boilerplate. Finally, while recent research documents an increase in environmental disclosures, assessing the credibility of (possibly “greenwashed”) disclosures may be particularly challenging for ESG investors, given the difficulty associated with measuring sustainability performance and the long horizons associated with sustainable strategies. Ultimately, whether ESG investors generally rely on companies’ disclosures to “walk the talk” is an open question.
To investigate whether environmental disclosure is associated with ESG fund ownership, we hand-collect the names of sustainability-focused mutual funds. We measure ESG ownership at the fund level and aggregate ownership across all ESG mutual funds to calculate: (1) the percentage of shares outstanding for a given firm held by ESG funds; and (2) the number of ESG funds holding the stock. To identify companies’ environmental disclosures, we measure the extent of environmental discussion in the risk factor section of the 10-K and firms’ conference calls. We start with text from the Global Reporting Initiative (GRI) environmental reporting standards. Published in 2000, the GRI standards take a “multi-stakeholder” approach and provide specific guidelines on various environmental topics. These are the most widely adopted reporting guidelines, with over 7,000 organizations worldwide voluntarily adopting the guidelines. To ensure that we are not capturing generic financial reporting language in our disclosure measures, we remove text that also appears in accounting textbooks and securities laws. We identify corporate environmental disclosures with language that overlaps with the text unique to GRI environmental disclosure standards. Environmental disclosures in the risk factor section of the 10-K and firms’ conference calls are steadily increasing over our 2009-2020 sample period.
We ultimately find a robust positive association between the level of firms’ environmental disclosures and ESG ownership in the subsequent year, controlling for firms’ ESG performance ratings, as well as a variety of firm characteristics and industry and time trends. We also investigate whether variation in firm-specific exposure to climate risks affects the link between firms’ environmental disclosure and ESG ownership. We find that the sensitivity of ESG investing decisions to firms’ environmental disclosure is increasing with firms’ exposure to climate-related shocks.
While the overall level of environmental disclosure indicates firms’ transparency around ESG issues, we also investigate the content and characteristics of environmental disclosure that are most relevant to ESG investing decisions. Specifically, we create topical measures of environmental disclosure using the contents of the GRI subsections and find those risk factor disclosures with more supplier assessment and energy discussion are associated with future ESG ownership. In contrast, general environmental, energy, and emissions conference call discussion is associated with future ESG ownership. We also find that more uncertain words (consistent with discussion of future climate-related risks) and negative words (consistent with a discussion of reducing environmental impact) are associated with higher ESG fund ownership. Finally, ESG fund ownership is also associated with more forward-looking and specific disclosures, consistent with this information being most likely to attract ESG fund investment. Overall, our evidence suggests that the quantity and contents of firms’ disclosures are associated with ESG funds’ investing decisions.
We perform several additional tests to help rule out concerns that our inferences are not spurious. For example, we do not find any evidence that environmental disclosures explain variation in future institutional ownership more generally. Moreover, our result is robust to controlling for the prevalence of greenhouse gas emissions disclosures typically underlying ESG ratings calculations.
Overall, our study helps inform the discussion around the investing choices of ESG funds by providing evidence consistent with ESG funds relying on other sources beyond firms’ ESG performance ratings when evaluating portfolio firms’ environmental performance. Our findings are also relevant to regulators seeking to understand the nuances of ESG investing. ESG-oriented funds’ investment strategies are under scrutiny around whether they are following through on their commitment to identifying firms with strong ESG performance. For example, the recent SEC investigation of BNY Mellon suggests that regulators are concerned that ESG investors are performing minimal reviews of firms’ ESG performance. Our findings suggest that ESG investors evaluate portfolio firms by looking beyond their ESG ratings to their disclosures, thereby better understanding firms’ exposure to environmental risks and opportunities.
Scott Robinson is a Ph.D. candidate in Accounting at the Leeds School of Business at the University of Colorado Boulder.
Jonathon Rogers is the Tisone Professor of Accounting and Chair of Accounting at the Leeds School of Business at the University of Colorado Boulder.
Nicole Skinner is an Assistant Professor of Accounting at the University of Georgia, J.M. Tull School of Accounting.
Laura Wellman is an Associate Professor of Accounting at the Smeal College of Business at Penn State.
This post is adapted from their “Environmental Disclosures and ESG Fund Ownership” post, available on SSRN.
I have personally had issues relying on est ratings.