There is a burgeoning awareness of corporate social performance in the current business climate. Yet, there remains much confusion over the value proposition of corporate nonfinancial investments in the environmental, social, and governance (ESG) areas. To date, the bulk of research attempts to link firm-level ESG ratings provided by third-party rating agencies to a wide array of firm valuation metrics in a single-country setting. While insightful, these studies continue to yield mixed conclusions about the value relevance of corporate social responsibility engagements.
The lack of robustness in previous findings is due in large part to the three inherent problems associated with firm-level ESG ratings: (1) rating agencies evaluate ESG based solely on publicly available information; therefore, firms may strategically attain a higher ESG score through selective disclosure; (2) since the cost of achieving a small increment in a firm’s ESG rating is not trivial, only firms with strong financial performance can afford substantive ESG investments to lift their social performance; and (3) firm-level ESG is determined by country characteristics, and thus results taken from a single-country setting could simply be a manifestation of the country-level institutional or social environment.
If ESG ratings are considered visible measures of “doing good” activities, these negative environmental and social (E&S) incidents are impact-oriented measures that reflect firms’ ability to avoid harm and are less subjected to corporate manipulation. Indeed, reputation is fragile, and anecdotal evidence suggests that “doing harm” has much greater bearing on firm reputation than “doing good.” For instance, while British Petroleum (BP) had invested for years in its global brand, its reputation quickly slipped away in the wake of the Deepwater Horizon Oil Spill disaster and firm value evaporated by some $100 billion dollars ex-post. Volkswagen always maintained a top 5 percent ESG rating in the Sustainalytics universe until it was found to cheat on US air pollution tests. This environmental violation wiped out nearly a quarter of the firm’s market value. These two examples vividly demonstrate the clear discrepancy between the rated reputation built through doing good and investor perceived reputation based on actual E&S incidents. Following E&S incidents, firms may face reputational risk, including a loss of trust from customers, suppliers, or employees, which may lead to the loss of sales revenue or hampered productivity. So far, there have been studies documenting immediate stock market reactions to capture the value impact of corporate E&S incidents. However, there are two major limitations with this approach. One, it largely manifests the extent of legal sanctions for the misconduct, but not the reputational damages that continue for months after. Two, it only reflects a short-term effect of corporate social irresponsibility that might not be long-lived. These shortcomings call for new research to revisit the stock market consequences of E&S performance based on observable E&S outcomes.
In a new study, we examine the cost of E&S risk in equity pricing across 25 countries by merging a global sample of seasoned equity offerings with over 50,000 ESG incidents for over 7,000 firms hand-collected by Sustainalytics analysts through at least 60,000 international and local media sources, social media, specialized publications, and non-government organizations.
For publicly listed firms, seasoned equity offerings (SEOs) are an important recurrent channel for external financing that enables the firm to pursue new growth opportunities or for liquidity to meet working capital needs. While initial public offerings are one-off capital-raising events, the number of times that a listed firm can raise capital using SEOs is unlimited. Based on our own calculations using the Securities Data Company (SDC) Platinum database for a sample of SEOs across 25 countries, the aggregate capital raised via SEOs is in fact three times greater than with initial public offerings (IPOs).
The offering prices of new shares are often set shortly before the offering day. Past studies find that new shares are often offered at a price below the prevailing market price, in a practice known as security underpricing, which is largely driven by the uncertainty and information asymmetry faced by investors. Such practice represents a substantial cost to the issuing firm. When announcing their intention to raise external capital, companies are immediately put under the media spotlight resulting in greater scrutiny by the investment community. During this period, investors seek more information that is relevant for pricing the company’s new shares. The emergence of recent E&S incidents likely alerts market investors of the potent E&S risk that may entail more acute conflicts with stakeholders in the future. This conceivably elevates the information uncertainty faced by equity investors. It also follows that companies’ E&S incidents would depress the market demand for its new shares and raise the cost of issuing equity capital. For the proponents of corporate social responsibility engagement, there would be no argument on how potential investors would respond; our society is increasingly more socially responsible rather than pure profit maximizers, and investors are likely to assess that corporate social irresponsibility presents adverse long-term consequences.
Our main findings in this study support the importance of E&S incidents affecting the cost of raising new equity capital. We show that the number of E&S incidents in the prior year aggravates the underpricing of new shares. From an economic perspective, every E&S incident that affected the issuer in the year prior to the equity capital raising increases the underpricing by 1.23 percent, which corresponds to 12 percent of the mean underpricing (equivalent to $5.10 million of the average seasoned equity offering). The fact that we find a significant impact of E&S incidents on subsequent equity raisings suggests that the stock market does not fully realize the reputational costs when these incidents are publicized for the first time. Most importantly, this finding confirms that equity investors lose confidence in the firm’s environmental and social accountability, thereby demanding a higher return (a lower offering price) to compensate for exposure to the E&S risk.
Why do E&S incidents affect the cost of raising equity capital?
Having established the impact of E&S incidents, we take a further step to examine why these incidents carry significant adverse effects on the cost of raising equity capital. We anticipate three possible channels at work: reputation risk, regulatory risk, and composition of the investor base. For the reputation risk channel, we explore two factors. First, in the aftermath of adverse events, a firm’s pre-existing social reputation buffers against reputational losses because investors are confident in the firm’s accountability and capability in recovering damages and preventing the recurrence of similar incidents in the future. Therefore, firms with stronger social reputations have lower reputation risk while those with weaker social reputations would have higher reputation risk. Indeed, we find that firms with worse reputations face higher costs compared to firms with better reputations. Second, a firm’s reputation risk in the wake of adverse E&S incidents may be exacerbated by how much the society cares about E&S standards. Our results reveal that companies experience a more pronounced impact if they are located in countries with a more socially- and environmentally-conscious society. Overall, adverse incidents affect the cost of raising equity capital because of heightened reputation risk.
While governments and regulators in certain countries prioritize sustainable development in their policymaking and regulatory framework, others lag behind. Firms located in countries with more stringent environmental and social policies are likely to suffer from higher regulatory risk. We find that the adverse consequences from E&S incidents are exacerbated in countries with higher environmental and social standards, suggesting that adverse incidents affect the cost of raising equity capital due to investors’ concern about the regulatory risk.
Generally, companies have various structures in terms of their shareholder base. Some have shareholders with large ownership, often referred to as block holders, some have a larger proportion of institutional investors while some have more main street investors. Block holders whom are incentivized to hold securities over a long-term investment horizon tend to align their investment preferences with stronger social performance. As such, the presence of block holders should bolster investor confidence on firm accountability in CSR engagements. We find that after firms experience adverse E&S incidents, they are not penalized with greater underpricing if there is a stronger presence of block holders. On the other hand, with a growing awareness of the importance of corporate stakeholder performance among institutional and retail investors, E&S incidents might push them to take the “exit” strategy. Indeed, our results find more pronounced effects on underpricing for firms with larger institutional and retail ownership.
What Are the Roles of Cross-country Institutional Environments?
Stakeholder reaction to corporate social irresponsibility may also depend on country-level institutional settings such as legal systems and cultures. While common law countries tend to give discretionary rights to managers, civil law countries promote state intervention through rules and regulations and thus can effectively monitor companies to provide socially responsible “public goods.” It follows that firms in civil law countries tend to be more responsive to CSR demands and adopt better CSR practices to rectify the fallout from undesirable E&S incidents. Indeed, our results reveal that the impact is more pronounced in firms from common law countries.
Another legal aspect we consider is the shareholder rights’ protection that differs across countries. Shareholder rights protection reflects the alignment of interests between managers and shareholders. Proponents of CSR would argue that firms with strong shareholder rights protection tend to see stakeholder protection as value-enhancing. Therefore, countries with stronger shareholder rights protection are likely to view corporate social irresponsibility as value-destroying. Our results show that E&S incidents increase underpricing for firms located in countries with stronger shareholder rights protection based on anti-self-dealing and rule of law measures.
National culture also plays a critical role in shaping societies’ perceptions of corporate social misconduct. In individualistic societies where shareholders’ interests are prioritised ahead of other stakeholders, managers do not see E&S incidents as an important concern and therefore are less likely to respond with better social accountability measures. Such a value norm raises investors’ caution about corporate social responsibility, which can cause firms in more individualistic societies to suffer greater reputational risk following E&S incidents. We show strong evidence that equity investors in individualistic societies are more likely to punish social and environmental misconducts by demanding higher returns. We also find that in countries less likely to accept inequality and injustice, investors penalize violating firms more, resulting in higher underpricing in equity issuances.
Conclusion
Our study sheds new light on the importance of corporate sustainability by demonstrating the repercussions of firms’ E&S misconduct on the cost of raising equity capital. The valuation impact of negative E&S incidents around new equity offerings reflects the growing investor attention paid to corporate social outcomes, particularly the adverse events that investors perceive to reflect firms’ true corporate social performance. Policymakers can help mitigate the adverse market impact of corporate E&S risk by introducing regulatory measures that hold firms to socially responsible corporate behavior.
Chloe Ho is a Lecturer at the University of Western Australia Business School.
Eliza Wu is an Associate Professor at the University of Sydney Business School.
Jing Yu is an Associate Professor at the University of Sydney Business School.
This post is adapted from their paper, “The Price of Corporate Social Irresponsibility at Seasoned Equity Offerings: International Evidence” available on SSRN.
