Corporate Social Responsibility and Asset Pricing in Industry Equilibrium

Abstract

Corporate social responsibility (CSR) represents a growing strategic concern for corporations around the world, many of which are adopting CSR as a core management or board-level function. The Global Reporting Initiative founded in the late 1990’s, embraced by the United Nations Environment Program, has provided corporations with a reporting framework on their economic, environmental, and social sustainability. No longer necessarily viewed outside the profit maximizing framework, many questions still remain on how CSR policies affect the risks firms are facing and the stock market implications of those policies. We aim to understand the asset pricing consequences of CSR adoption, but also of non-adoption in the presence of industry CSR trends. We plan to develop an industry equilibrium model where firms make production and CSR investment decisions and embed this model within a standard asset pricing framework. Following the exiting work in finance and marketing, we model an investment in CSR as a mechanism to acquire customer loyalty. Greater customer loyalty takes the form of a less price elastic demand, which the firm uses to smooth out the effect of demand fluctuations. With this assumption, the model captures the folklore view in the literature that a firm with a more loyal demand has profits that are relatively less sensitive to aggregate economic conditions than a firm with a less loyal demand. A risk averse investor will therefore, all else equal, value more highly the firm with the more loyal demand, pricing a lower systematic risk (lower beta) and expecting a lower return. We will test the model predictions using a comprehensive dataset on firm-level CSR from MSCI’s Environmental, Social and Governance (ESG) database. The database provides coverage for companies that constitute several major international stock indices. The full sample includes 34 countries and 3,005 firms from 2004 to 2010, equivalent to an unbalanced panel with 9,795 firm-year observations. To address the endogenity issues, we will create two instruments for CSR. The first instrument is based on the sample of environmental and engineering disasters. The second instrument is based on data on product recalls. We adjust these data for their relevance using hand collected data on newspaper articles before and after the incidents. Our results will have important practical capital budgeting and policy implications. Beta is the major parameter used in estimating the cost of equity. Given our results, we expect CSR companies to have lower cost of equity than non-CSR firms. In addition, projects that increase firms’ reputation for CSR should be discounted with lower cost of equity, compared to otherwise similar projects. Thus, for example, investments in green energy should be discounted with a lower cost of equity than investments in more polluting sources of energy.