Natural Experiments on the Impact of Financial Performance on Subsequent Changes in ESG Ratings

Abstract

Much of the current reporting in the financial press suggests that companies with superior environmental, social, and governance (ESG) ratings outperform their competitors financially. However, and despite numerous studies on the relationship between a corporation’s financial performance (FP) and its ESG score, researchers are yet to reach a consensus on whether there is indeed a causal relationship between FP and ESG. Here, we explicitly investigate the issue of reverse causality – while better ESG performance might lead to higher subsequent FP due to improved corporate reputation and less investment risk, it can also be argued that companies with higher FP have more slack resources, which are used for subsequent ESG investments. Endogeneity may mask the genuine relationship between variables; hence we employ a natural experiment method, using three distinct large-wave exogenous shocks in the market (the Enron/Worldcom scandal, the global financial crisis, and the introduction of Obama’s climate change bill) to attempt to resolve this issue. Consistent with the slack resources theory first proposed by Waddock and Graves (1997) in the FP?ESG context, we find that corporations with superior FP in one period have more engagement in ESG-related activities in subsequent periods. We use both accounting-based and market-based measures for FP, and our results remain robust for all three exogenous shock episodes. We conclude by discussing implications for future research.