Research challenges relevance of popular ESG scoring models for investment returns

Photo illustration shows a woman's hands typing on laptop and pointing to a checklist labeled environmental, social, governance.
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The ESG investing industry has attracted trillions of dollars, in part through marketing that tells investors they can “do well by doing good.” 

Thousands of funds and other investment products have been created around the idea that identifying companies with rising scores on environmental, social, and governance (ESG) measures can lead to market-beating returns. 

Yet a new paper co-authored by Berkeley Haas accounting professor Panos N. Patatoukas, forthcoming in The Accounting Review, suggests that outperformance attributed to improving ESG scores—as measured by current standards—may be a mirage.

“Sorting out correlation from causation is critical in the debate over ESG investing, and we found correlation, not causation,” Patatoukas says. “Our research finds there’s no hidden information in proprietary ESG scores beyond what is already contained in easily accessible financial reports.” 

The researchers—who include Byung Hyun Ahn, PhD 21, of Dimensional Fund Advisors, and George S. Skiadopoulos of Queen Mary University of London—found that larger, more stable, and more profitable companies are the ones more likely to have their ESG scores upgraded. These are the companies with the most resources to devote to fixing any weaknesses in their ESG scores and promoting their improvements. 

But any above-market returns attributed to ESG scores disappeared when the researchers controlled for revenue, growth potential, and other factors used in traditionally used to screen stocks. 

“Trillions of dollars of value have been allocated according to the idea that you can do the right thing and beat the market,” Patatoukas says. “Our data challenge this idea.”

“Trillions of dollars of value have been allocated according to the idea that you can do the right thing and beat the market. Our data challenge this idea.” —Professor Panos Patatoukas

The research does not imply that companies should turn away from efforts to reduce their carbon footprints, become more socially responsible, and be better corporate citizens—rather, those efforts must accelerate in the face of the climate crisis, Patatoukas says. He argues it’s the ESG measurement system that needs a major overhaul to incorporate information that goes beyond what is already reflected in corporate financial statements in order to give investors the transparency to make decisions in line with their values.

Questioning ESG frameworks

As of late 2023, $2.74 trillion was invested globally in funds that track companies with better sustainability scores, according to Morningstar. Last August, Bloomberg counted 14,500 funds with ESG called out in their prospectuses, holding $7 trillion in assets. And despite a recent political backlash and some $13 billion in outflows last year, trillions remain invested in ESG funds globally.

The question of whether ESG issues have a material impact on stock prices is critical to the industry. The search for an answer has spawned an ecosystem of standard-setting organizations, rating agencies, and index providers. At the foundation of this ecosystem is a materiality framework with industry-specific disclosure standards developed by the Sustainability Accounting Standards Board (SASB). 

Prior academic research, as well as researchers at McKinsey, Charles Schwab, Morgan Stanley, and others, have found that companies with higher ESG scores can match or exceed benchmark-adjusted returns, often due to factors like lower costs, less regulatory pressure, and higher productivity. Such outperformance, known as “alpha,” is the holy grail of the investing industry.

“Index fund managers and index providers often cite evidence of ESG alpha as evidence of the value of the SASB materiality framework,” Patatoukas says, adding that some financial leaders might even cherry-pick benchmarks to show above-market returns.

Yet Patatoukas and his co-authors showed ESG alpha to be elusive. Through an analysis of the MSCI/KLD indicators of ESG strengths and weaknesses for U.S. public firms, they concluded that financially established companies—characterized by larger size, lower growth, and higher profitability relative to their sector—are associated with higher ESG scores because they are more likely to resolve material weaknesses and create strengths in their ESG scoring. But there’s no new information embedded in a rising ESG score that hasn’t already been priced into a stock’s price, he says.

“Our evidence shows that a simple benchmark portfolio based on established firms is indistinguishable—both in terms of performance and overall ESG score—from a portfolio based on firms with rising ESG scores,” he says. “Investors could target an overall ESG score by selecting portfolio stocks on fundamental firm characteristics, which is simpler and cheaper.”

“Investors could target an overall ESG score by selecting portfolio stocks on fundamental firm characteristics, which is simpler and cheaper.” 

As an external validity test, the researchers also analyzed the performance of the Bloomberg/SASB index family powered by State Street’s “Responsibility Factor” (R-Factor), which is aligned with the SASB materiality framework and draws from several alternative ESG data sources. They found that,  compared with matched benchmark indices that do not incorporate ESG considerations, the Bloomberg/SASB indices do not generate additional returns. 

Troubling lack of transparency

Patatoukas finds the current system troubling for a few reasons. First off, socially and environmentally responsible small and mid-sized companies may be penalized because they have fewer resources to devote to the logistics of ESG reporting. Second, the current frameworks might allow a company to get upgraded even if it becomes less environmentally efficient, and might penalize a company for being more transparent than its competitors. 

For example, a company might opt to be fully transparent and include data on all of its contractors—including carbon emissions from their activities, and even injury rates experienced by contract workers. Another company might only include its direct employees and receive higher ESG scores.

The research also takes issue with the premise that more environmentally and socially responsible portfolios need to outperform the market—the very idea of “doing well by doing good.” Though this may be possible, investment outperformance is not an indication of environmental or social progress, but rather a measure of capital transfer across investors who are buying and selling, he says. 

“Social welfare creation involves directing investments toward companies and projects that positively impact society and the environment,” he says. “The time is ripe to evaluate the real effects of corporate sustainability reporting in terms of mobilizing capital to enable the transition to a more sustainable economy.”

New measurement targets

So what should be measured to allow people to make investment choices in line with their values? That question will be a key topic of a conference on March 20 at Berkeley Haas organized by the Center for Financial Reporting and Measurement, titled “Corporate Sustainability Measurement and Reporting: From Whether to How.”

Patatoukas says we’re getting closer to measuring what matters with ESG in terms of a company’s carbon emissions. This metric comes with strong measurement incentives. California is leading the charge with the first-in-the-nation disclosure requirements about carbon emissions. For example, under the Climate Corporate Data Accountability Act coming into force in 2026, California will mandate that both public and private companies with more than $1 billion in revenue disclose details about their carbon emissions. 

The European Union has its own environmental disclosure requirements under its Corporate Sustainability Reporting Directive (CSRD), which applies to non-EU entities that meet certain thresholds. The U.S. Securities and Exchange Commission approved new rules this month on how companies should disclose climate risks, but they were almost immediately halted by a federal court.

Efforts at greater transparency could falter if firms don’t accurately measure indicators that meaningfully capture, in granular detail, each of the individual performance factors of ESG, Patatoukas says. This will require the intersection of different disciplines—finance, accounting, economics, operations, climate science, and software engineering. 

“The massive opportunity here is measurement—to go beyond measuring the companies that are good at checking all the boxes and develop a way to measure those that make significant strides towards our decarbonization path,” Patatoukas says. “Better measurement will facilitate more efficient allocation of capital and accelerate transition to a more sustainable future.”