A Survey Paper on Corporate Environmental Responsibility

A Survey Paper on Corporate Environmental Responsibility
Course: ECONGR5120_001_2022_3 - Research in Economics
Date: 22/10/2022
Table of Contents 1.0 INTRODUCTION.. 3 2.0 PRESENT RELATED CORPORATE ENVIRONMENTAL RESPONSIBILITY. 4 2.1 Climate Change and Financial Markets. 4 2.2 Impact of Risks and Uncertainties on Mitigation Measures. 5 2.3 Investors and the ESG Rating. 5 2.4 Effectiveness of ESG Rating. 7 2.5 Climate Finance. 7 3.0 DO INVESTORS CARE ABOUT FIRMS’ ENVIRONMENTAL PERFORMANCE?. 8 3.1 Environmental risks and Investment decisions. 8 3.2 Institutional Investors and Environmental Performance and The Impact of the ”Big Three.”. 9 3.3 Corporate Green Bond and Green Signal 12 3.4 Environment Consciousness or Marketing Strategy?. 15 3.5 Index Funds and Monitoring Inefficiency. 17 4.0 ESG CRITERIA AND “GREENWASHING.”. 18 4.1 Divestment and ESG rating. 18 4.2 Green Innovation and ESG rating. 25 4.3 Environmental Policy and Limited Liability Protection. 27 5.0 NEW RESEARCH DIRECTION.. 28 5.1 Research Question and Motivation. 28 5.2 Literature. 30 5.2.1 Sustainable investment equilibrium.. 30 5.2.2 The product market outcome of ESG investment. 30 5.2.3 ESG-innovation studies. 30 5.3 Research Design. 31 5.3.1 Data. 31 5.3.2 Methodology. 31 6.0 CONCLUSION.. 32 Bibliography. 33 Appendix. 38   1.0 INTRODUCTION
Climate change is among the key concerns today, with companies and governments worldwide seeking better ways to control climate change. Industries and businesses significantly negatively impact the environment due to their massive consumption of natural resources and emissions of hazardous pollutants. Many businesses pursue environmental sustainability not only as a moral obligation but also as a business opportunity in the present day. Corporate social responsibility evaluates a company's performance based on how well it manages its social and environmental impacts and financial performance. Most businesses recognize that sustainability is a market necessity and not a choice. To further their interests, businesses frequently distort the truth about sustainability. This report focuses on the environmental aspect of ESG (Environmental, Social, and Governance) by researching existing literature that covers corporate environmental responsibility to propose a new research direction in the end. The paper begins by reviewing three of the most frequently asked questions about corporate environmental responsibility. For each question, there is a summary that highlights the strengths and weaknesses of papers that addressed these questions.
Some businesses work to reduce their contribution to climate change by reducing energy consumption, producing clean energy, or offsetting their greenhouse gas emissions with carbon credits. Another instance of circularity is the capture and subsequent use of carbon or methane. Business leaders, including capital providers, can work to preserve shared value in the coming decades to keep chaos from causing harm to all of us. It necessitates a comprehensive benefit-cost analysis that accounts for an uncertain future with unequally distributed risks. The best financiers, operators, inventors, and decision-makers will, presumably, evaluate risks as they evolve. The value of environmental justice and public health co-benefits will be fully accounted for as they narrow their options in engineering, finance, construction, sensors, and climate risk modeling.
Institutional ownership enhances environmental performance for climate change mitigation. At the same time, a company's initiative to reduce carbon emissions is driven by investors' financial and environmental returns (Dyck et al., 2019). Large institutional investors might improve the financial performance and environmental performance of businesses. Thus, it is uncertain whether the improved business environment performance was brought on by these investors' improved financial circumstances or by changes in societal norms. To address these potential endogeneity issues, Azar, Duro, Kadach, and Ormazabal (2021) looked into the impact of the "Big Three"—BlackRock, Vanguard, and State Street Global Advisors—on corporate carbon emission reductions globally.
The paper is organized as follows: I cover existing literature concerning corporate environmental responsibility in section 2. After that, I focus on the debate on investors’ environmental preferences in section 3. The fourth section discusses empirical evidence on ESG criteria and “6Greenwashing”. After that, Section 5 explains whether shareholder welfare maximization or shareholder value maximization should be implemented in practice and proposes a new research direction. Lastly, Section 6 concludes this paper.
2.0 PRESENT RELATED CORPORATE ENVIRONMENTAL RESPONSIBILITY
2.1 Climate Change and Financial Markets
One of the most important issues of our day is climate change, which can potentially affect the health and happiness of almost everyone on the globe. Additionally, the economy and financial system are exposed to significant overall risk from climate change (e.g., Litterman et al., 2020). Therefore, the instruments of financial economics, created for valuing and controlling dangerous future events, can assist society in evaluating and responding to the risk of climate change. Giglio, Kelly, and Stroebel (2021) find that the literature has paid less attention to several significant financial aspects of climate change economics, such as the pricing and hedging of risks resulting from climate change, investor awareness and attitudes toward these risks, and the influence of climate risks on investment decisions. Researchers in financial economics have only recently started to investigate these issues. Researchers use financial economics to analyze climate change because financial markets offer a platform for hedging climate risk. Indeed, sharing and transferring risks is one of the core purposes of financial markets. Even though climate risk is an aggregate risk, there are considerable opportunities for risk sharing due to the heterogeneity in how firms and regions are exposed to climate change. Likewise, some investors are better suited to tolerate this risk than others due to variability in adaptability and risk tolerance.
Giglio, Kelly, and Stroebel's work from 2021 goes on to analyze the literature and attempts to include climate risk in macro-finance models. For instance, Nordhaus (1977) paved the way for thinking about the physical interaction between the real economy and climate change. Working in deterministic settings, Nordhaus (1977, 1991, 1992) focused on the most effective ways to combat climate change. However, the influence of climate change on asset price and risk premia was not particularly covered in these articles. In later research, these models have been expanded to incorporate additional risk and uncertainty factors relating to climate change and its effects on the economy. The stochastic nature of physical and economic processes, as well as uncertainty surrounding models of these processes, are, for instance, both present in the work below (e.g., see Kolstad 1993; Manne Richels 1992; Nordhaus 1994; Nordhaus Popp 1997; Kelly Kolstad 1999; Weitzman 2001, 2009; Lemoine Traeger 2012; Golosov et al. 2014).
2.2 Impact of Risks and Uncertainties on Mitigation Measures
The impact of risks and uncertainties on the most efficient mitigation measures and the social cost of carbon has received considerable attention in this research. More recent financial economics research looked into how these models impact the returns and pricing of financial assets. The empirical study that studies the pricing of climate risk across various asset classes considers two main types of climate-related risk variables: physical and transition risks. The key finding of the research technique in these publications is that assets are differentially vulnerable to certain climate risk indicators. Then, numerous articles combine the changing exposure of assets within an asset class with varying attention to climate risk to understand how climate risk is valued in asset markets. The literature analysis by Giglio, Kelly, and Stroebel on how climate change affects asset prices in equity markets, including stock markets, bond markets, housing markets, and mortgage markets, was very good. They also provide a very clear description of recent research that shows how financial assets can be utilized to create portfolios that reduce the risks related to climate change.
Generally, companies worldwide emphasize mitigating climate change and reducing their emissions to acceptable levels. In addition, recent finance literature provides theoretical and empirical evidence about whether and why investors should consider portfolio firms’ environmental performance. Studies show that investors care about the environmental performance of firms when they make investment decisions. Studies by Krueger, Sautner and Starks (2020) observe investors’ implementation techniques when making investment decisions. For instance, a natural question that arises is whether environmental investments are beneficial to these investors if they are a driving force behind firms’ environmental choices. For instance, if investors favor a company through its better ESG rating, how will this company allocate the superior resources it receives from investors? Consequently, will this company continue to invest resources in improving its ESG performance to keep enjoying superior resources?
2.3 Investors and the ESG Rating
According to Flammer (2021), firms must submit to third-party verification to ensure that earnings are going toward environmental projects that reduce climate change by adopting costly signals such as "certified" green bonds. The audited firm, on the other hand, chooses, pays, and reports to the auditor. This feature creates a conflict of interest between telling the truth and acting in the client's best interests (Duflo, Greenstone, Pande, and Ryan, 2013). To continue in business, third-party auditors may fabricate information or distort data in their reports, thus tainting the flow of information and weakening regulation. In reaction to the SEC's climate disclosure mandate, a group of law and finance professors argued that investors may have little or no motivation to ensure companies are keen on mitigating climate change and overall improvement of environmental performance.
The letter highlights BlackRock, State Street, and other major index fund providers experiencing a challenging competitive environment. Their public claims that climate change is a major concern may just be a key component of their aggressive marketing strategies. However, because environmental risks are difficult to insure and have a significant impact on the performance of portfolio companies, index funds' advocacy for environmental protection and support for social causes is reasonable. Heath, Macciocchi, Michaely, and Ringgenberg (2021) add to the letter's arguments by demonstrating that index funds compete to provide a standardized good at the lowest price, making them less effective monitors and worsening corporate governance due to their limited resources. The results, however, do not make logical sense to me because index funds should have significant incentives to monitor and uphold good governance, given their substantial investments in businesses and the costly exit of a stake. In section one, I provide some support for this claim.
Numerous literary works discuss the issue that shareholder and stakeholder interests rarely align and frequently conflict. Bebchuk, Kastiel, and Tallarita (2022) assert that misinterpreting the extent and frequency of win-win scenarios is the source of support for stockholder welfare maximization. However, Bebchuk, Kastiel, and Tallarita (2022) and stockholder value maximization fail to address the issue of what to do when the government must address a global externality, such as climate change, which requires international collaboration.
Broccardo, Hart, and Zingales (2022) demonstrate how pressure from stakeholders will likely result in socially good outcomes such as climate change mitigation. They remark that only those agents with a social responsibility criterion exceeding a threshold will choose to quit or divest. If the most socially responsible investors and customers are unwilling to pay for the majority of the cleanup costs, the only equilibrium is that nobody divests or boycotts, and no enterprises get cleaned up. According to the model of Broccardo, Hart, and Zingales (2022), if investors rarely utilize a divesting (exit) strategy in practice (as much empirical evidence suggests), this inevitably means that all investors have a below-average social responsibility. The failure to include empirical evidence in the models of Broccardo, Hart, and Zingales (2022) may render the models inconsistent with practice. Due to their ownership structure, Shive and Forster (2020) found that private enterprises are less likely to get EPA fines and that the total number of fines tends to be smaller than for public firms. There may be endogeneity difficulties, for instance, regulators may emphasize monitoring large public corporations, as they typically receive more public attention than private firms. Due to their substantial social impact, public firms may have a greater likelihood of getting detected by the EPA, and consequently, the fines may be higher.
2.4 Effectiveness of ESG Rating
Since 2015, the average value of divestments of polluting assets has increased significantly due to rising environmental concerns and pressure from regulators, activists, and environmental, social, and governance (ESG) advocates. It has therefore highlighted the question of the effectiveness of such divestments and ESG standards in general. By analyzing the reallocation of industrial pollutants through the purchases and sells of divested assets in the real asset market, Duchin, Gao, and Xu (2022) provide a solution to this question by elucidating the incentives and economic dynamics underlying the movement of divested assets. According to Duchin, Gao, and Xu (2022), when polluting plants are sold, the selling businesses receive higher ESG ratings, while the purchasing companies receive larger market shares. However, it is unclear how the corporations will weigh the deal's profits and losses. Knowing the intricacies of the tradeoff can provide insight into how much corporations are willing to sacrifice for a higher ESG grade.
To further analyze how ESG effectively helps stakeholders, Cohen, Gurun, and Nguyen (2021) describe how enterprises with poor ESG scores usually act as leading innovators in the United States' green patent ecosystem. They believe that these corporations' major contributions to the progress of green technology are not reflected in their ESG scores. However, ESG is not the only issue investors consider when selecting assets. Assessing a company's financial performance is a first-order task for investors. Although these traditional energy businesses have made substantial financial investments in their research and development sections, it is uncertain whether or not their financial performance is still competitive. Akey and Appel (2021) assert that because restricted liability caps the parent firms’ potential losses, corporate owners do not necessarily bear the costs of hazardous activities. This explains why treated plants have increased ground emissions.
2.5 Climate Finance
Climate finance is one of the most popular academic sub-fields currently. It investigates regional and global funding sources for public and commercial climate change adaptation and mitigation efforts. According to Hong, Karolyi, and Scheinkman (2020), an acceptable climate finance study plan is offered in their Review of Financial Studies review of the most current studies on the subject. By combining asset pricing approaches and decision theory to estimate the social cost of carbon, Barnett, Brock, and Hansen (2019) contribute to the discussion on the use of discount rates in the literature on climate economics. According to Engle et al. (2019), conventional portfolio management strategies might create additional issues, such as climate risk management. The nine projects selected for this particular RFS are all aesthetically pleasing publications that provide vital insight into the future of climate finance research.
3.0 DO INVESTORS CARE ABOUT FIRMS’ ENVIRONMENTAL PERFORMANCE?
3.1 Environmental risks and Investment decisions
Do investors care about a company's environmental performance? This is the first and most commonly asked question about corporate environmental responsibility. Recent finance literature in academia offers theoretical and empirical support for whether and why investors take portfolio firms' environmental performance into account. For instance, several asset pricing models emphasize the significance of environmental risks as a long-run risk factor and the impact of carbon risks and environmental pollution in the cross-section of stock returns (Bansal, Kiku, and Ochoa 2017). According to Bolton and Kacperczyk (2019), integrating environmental risks into the investment process can be difficult due to the lack of well-established investment instruments and best practices, despite growing empirical evidence that investors should consider corporations' environmental performance. Institutional investors, for instance, find it challenging to hedge and price environmental risks. This can be because they are systematic, portfolio companies are not disclosing enough, or—most crucially—hard it's to locate the right hedging products.
Krueger, Sautner, and Starks (2020) use a survey instrument to understand whether and how institutional investors consider environmental risks in their investment decisions. They examine how investors view and manage environmental risks and reveal that a systematic cross-sectional variation exists in their opinions about environmental risks and their strategies to manage these risks. This study uses the survey, which is a good way to observe investors' implementation strategies because they can occasionally be challenging to identify when using archive methods. However, it is important to note that the survey's respondent group is probably biased toward investors with a good understanding of environmental issues and perhaps have more training in environmental risk management. The writers of the Comment Letter on the SEC climate disclosure rule (Sharfman, 2022) emphasize the difficulty in reaching an agreement on contested political issues of nebulous and inchoate corporate significance, such as environmental change. People's views on this matter diverge greatly, and investors have different viewpoints on matters relating to the climate, such as whether and how to incorporate the idea into their investment procedures.
Some investors have started doing so with considerable fanfare, while others have no ambitions. Many investors have been doing this implicitly for a long time. Additionally, the investors who responded to the poll were incentivized to misrepresent themselves to prevent their competitors from learning their investing plan. The results of this poll are, therefore, less generalizable and unrepresentative due to this unique respondent group.
Moreover, this survey reveals that investors believe environmental risks have significant financial implications for portfolio firms. The index funds’ fees are almost zero, and their profits rely on spreading the managers’ fixed costs over a larger pool of managed assets. To attract fund inflows, index funds compete against each other and with active managers. However, active managers have a built-in advantage in attracting socially conscious investors because they can offer non-indexed products (which cater to ESG-focused investors). Barzuza, Curtis, and Webber (2020) reveal that for the manager of an index fund that must invest in all or substantially all companies in the index, publicly declaring that climate change is a top priority across the entire portfolio can be just an important competitive marketing tool.
3.2 Institutional Investors and Environmental Performance and The Impact of the ”Big Three.”
Evidence indicates that investors care about the environmental performance of firms when they make investment decisions. Therefore, a natural question that arises is whether environmental investments are beneficial to these investors if they are a driving force behind firms’ environmental choices. Dyck, Lins, Roth, and Wagner (2019) apply international evidence to assess whether shareholders drive the environmental performance of firms and how they benefit from it worldwide.
According to research by Dyck, Lins, Roth, and Wagner (2019), institutional ownership is positively correlated with environmental performance, and investor returns on their investments—both financial and environmental—are key factors in a company's environmental improvements. Additionally, investors who have signed the United Nations Principles for Responsible Investment (UN PRI), which obligate them to engage in environmental activism, have an impact on a company's environmental performance that is more than twice as great as the average investor. Additionally, firms with initial environmental scores below the median have more room to improve their environmental performance due to the influence of investors. Finally, this study uses the 2010 BP Deepwater Horizon oil spill as a quasi-natural experiment and finds that firms with higher institutional ownership at the time of the shock are predicted to be more responsive in terms of improving environmental performance in the years following this shock.
However, there might be some potential endogeneity issues related to the 2010 BP Deepwater Horizon oil spill shock that biased the causal inference among investors and firms’ environmental policy. The 2010 BP Deepwater Horizon oil spill was a costly environmental disaster that may have encouraged the authorities to enact more stringent laws and higher environmental protection standards that force firms to follow. Firms may be subject to many penalties if they fail to comply. Since institutional investors used to have large stakes in firms, they tend to be vulnerable to these penalties incurred by the government. Hence, it is probable that investors prioritize changes in the company’s environmental policies to prevent related penalties.
This study shows that instead of choosing companies with strong environmental performance or getting rid of companies with weak environmental performance, investors engage with the companies they already own. However, if index funds are concerned about the environmental performance of businesses, they should monitor businesses. Index funds compete to offer a standardized product at the lowest price, according to empirical evidence such as Heath et al. (2022). Hence they are less effective monitors due to the limited resources. More specifically, we would anticipate a change in the number and nature of agenda items proposed at the annual meeting following an exogenous increase in index funds' holdings if index funds do interact with the managers of the firms in their portfolio to alter governance or environmental policies. For instance, fewer divisive management suggestions are anticipated. However, Dyck, Lins, Roth, and Wagner (2019) do not provide proof that the volume of shareholder or management suggestions, or the proportion of controversial proposals, has changed. Therefore, even if it appears that index funds are interacting with companies, according to Dyck, Lins, Roth, and Wagner, it is unclear to us whether they have an excessive motivation to improve the firm's environmental performance (2019).
Dyck, Lins, Roth, and Wagner (2019) argue that norms may influence investors when determining the degree of the environmental performance of a corporation. Their research demonstrates that foreign institutional investors only impact firms’ environmental performance when they come from nations where social norms indicate a higher demand (above the median) for environmental performance and where strong norms toward environmental performance are the norm rather than weak norms. However, there could be some possible endogeneity problems concerning the influence of foreign institutional investors on the environmental performance of enterprises. According to Dyck, Lins, Roth, and Wagner (2019), European countries account for most foreign institutional investors with strong rather than weak standards for environmental performance and higher demand (above median) for environmental performance. These investors are more qualified and experienced than others because most are from wealthy, developed European countries. As a result, the additional capital and managerial skills these investors provide may result in better corporate financial performance and, consequently, better environmental performance. Therefore, it is unclear if the enhanced corporate environmental performance is a result of the improved financial conditions experienced by European investors or a result of their societal norms. Azar, Duro, Kadach, and Ormazabal (2021) try to address these potential endogeneity problems by studying the impact of the ”Big Three” (i.e., BlackRock, Vanguard, and State Street Global Advisors) on the reduction of corporate carbon emissions around the world.
Azar, Duro, Kadach, and Ormazabal (2021) focus on the Big Three to study the role of investors in the economy since the large stakes in their portfolio firms make them likely pivotal voters (Bebchuk and Hirst, 2019b; Griffin, 2020). This also gives the Big Three an influential role and facilitates their engagement with portfolio companies (Fichtner et al., 2017; Fisch et al., 2020). Azar, Duro, Kadach, and Ormazabal (2021) believe that the Big Three are incentivized to engage with firms on environmental issues since reducing carbon emissions increases the value of their portfolio. Azar, Duro, Kadach, and Ormazabal (2021) analyze carbon emission data for a wide cross-section of firms between 2005 and 2018 and data on Big Three engagements with individual firms to show that firms with higher carbon emissions are more likely to be the target of Big Three engagements. Azar, Duro, Kadach, and Ormazabal (2021) further find that a reduction follows the Big Three engagements in carbon emissions.
There are a few limitations related to this paper. This paper shows a negative relationship between the Big Three engagements and carbon emissions. There is a probability that the Big Three choose financially well-performed firms in the first place, and these firms tend to be environmentally well-performed as well. So they can continuously invest in improving environmental performance. That being said, the Big Three’s engagements do not necessarily relate to firms’ reduction in carbon emissions. Azar, Duro, Kadach, and Ormazabal (2021) may argue that they further sharpen identification by exploiting the yearly reconstitution of the indexes Russell 1000 and Russell 2000 and find that the exogenous changes in Big Three ownership driven by the inclusion in this index are followed by lower subsequent carbon emissions. However, this approach is not quite reliable.
Regarding the impact of index assignments on a firm’s ownership structure and corporate policy, empirical approaches that rely on Russell 1000/2000 index assignments for identification may produce contradictory findings. Some estimators (such as those that use a sharp regression discontinuity estimation) probably exhibit bias. In contrast, others do not (e.g., using a fuzzy regression discontinuity or an instrumental variable estimation). However, it is unclear what estimation Azar, Duro, Kadach, and Ormazabal (2021) applied in the paper.
Additionally, the fact that the Big Three are more likely to become important voters for the corporations is another reason why Azar, Duro, Kadach, and Ormazabal (2021) concentrate on them while researching the function of investors in the economy. However, index investing provides a free-rider issue since while gains in company value are shared by all funds that adhere to the same index, the costs are only incurred by the fund that makes the monitoring effort (Bebchuk et al. 2017). Furthermore, because low-fee index funds are far more likely to vote in favor of management, their low-cost structure directly affects their ability to monitor. We do not have a strong understanding of how effect...