Environmental, Social, and Governance Performance and Downside and Upside Risks

The term “environmental, social, and governance (ESG)” was first mentioned during the United Nations Global Compact Leaders’ Summit to determine how ESG activities can be integrated into capital markets. Since then, these activities have become a key priority for firms, investors, and other stakeholders.

Sustainable and responsible investment in the United States (US) has grown exponentially, from $639 billion in 1995 to $17.1 trillion in 2020 (US SIF 2020) (Figure 8.1). Firm commitment is growing and increasingly willing to incorporate these activities into business and investment strategies. In 2019, 222 CEOs of the largest US companies signed and issued the “Statement on the Purpose of Corporation” in a business roundtable and committed to lead their companies in the best interests of all stakeholders: employees, customers, suppliers, and shareholders. The statement disregarded shareholder supremacy and reinvigorated contrasting views about shareholder and stakeholder orientations of firms (Harrison, Phillips, and Freeman 2020). Firms holding the shareholder view try to maximize their profits (as the core firm objective), assuming shareholders to be the key stakeholders (Eccles, Ioannou, and Serafeim 2014). In contrast, other companies presume a stakeholder view to account for the externalities of their activities and how they influence other stakeholders (Deegan 2002, Friedman and Miles 2002). To maintain both approaches, effective stakeholder engagement through ESG activities requires not undermining investor interest while delivering value to other stakeholders (Dumitrescu and Zakriya 2021). This raises a question: Do ESG activities undermine investors’ interests in practice? One way to answer is to examine the effect of ESG activities on firm risk.