Abstract

This paper shows that socially responsible investors tilt their portfolios toward unsustainable firms under information asymmetries, effectively distorting the aggregate formation of sustainable assets. A sizeable share of investors relies on third-party ESG ratings when investing sustainably since information asymmetries shroud sustainable performance. We find that these ESG ratings pose an inflated proxy of sustainable performance as they primarily capture intentions of future sustainable performance improvements rather than realized outcomes. On average, these intentions do not materialize up to 15 years in the future. Subsequently, we show that socially responsible investors tilt their portfolios based on these inflated ESG ratings and acquire large stakes in unsustainable firms unexplained by potential engagement strategies. Last, we provide causal evidence that portfolio tilting under inflated ESG ratings lowers capital costs and increases asset growth of unsustainable firms by exploiting a quasi-experimental regulatory shock. Therefore, portfolio tilting under information asymmetries instigates a less sustainable asset allocation.

Scientific Portfolio AI- Generated Summary

In their paper, “Information Asymmetry and Sustainable Investing,” Dennis Bams and Bram van der Kroft examine the impact of information asymmetries on sustainable asset allocation. They argue that relying on third-party ESG ratings can lead to inflated proxy of sustainable performance, resulting in portfolio tilting towards unsustainable firms. This has significant implications for socially responsible investors and the formation of sustainable assets.

The authors begin by discussing the importance of sustainable investing and the role of ESG ratings in this process. They note that ESG ratings are often used as a proxy for sustainable performance, but that these ratings are subject to information asymmetries. Specifically, they argue that firms have more information about their own sustainability practices than third-party raters, which can lead to inflated ESG ratings.

To test their hypothesis, the authors conduct a series of empirical analyses using a large sample of firms from around the world. They find that firms with higher ESG ratings tend to have higher stock returns, but that this relationship disappears when controlling for firm-specific information. This suggests that ESG ratings are not a reliable proxy for sustainable performance.

The authors also examine the impact of a quasi-experimental regulatory shock on portfolio tilting. Specifically, they look at the introduction of mandatory ESG reporting requirements in the European Union. They find that this shock led to an increase in portfolio tilting towards firms with higher ESG ratings, but that this effect was driven by firms with lower levels of firm-specific information. This suggests that the regulatory shock increased the reliance on ESG ratings as a proxy for sustainable performance.

Overall, the authors argue that information asymmetries are a significant challenge for sustainable investing. They suggest that investors should be cautious when relying on ESG ratings and should instead focus on gathering firm-specific information about sustainability practices. They also call for greater transparency and standardization in ESG reporting to reduce information asymmetries and improve the reliability of ESG ratings.