Green Choices, Grey Areas: Risk Management and Investor Behavior in the ESG Landscape

Abstract

Higher corporate responsibility can mitigate risk. However, the specific channels through which this occurs are not yet clear. Operational risk can serve as the root cause for risks through the frequency and severity of operational risk events. The dissertation explores using fixed effect panel regressions and Heckman selection, how ESG scores correlate with the severity and frequency of operational loss events. Here, we seek to understand if companies with better ESG scores are more resilient when faced with operational challenges. We find no evidence for the effects of ESG performance on the frequency of corporate misconducts. However, we conclude that a one-unit of improvement in the ESG, E, or S scores decreases the severity of corporate misconducts by 3.55%, 2.85%, and 3.57% respectively. Consequently, one standard deviation (19.42) higher ESG score decreases loss severity by 50-58%, which is a significant effect also in economic terms. The aggregate effect can be attributed to pillars E and S, because G scores are not significant in most of the specifications, which is consistent with findings in the empirical literature. We also dig into the relationship between ESG scores and various operational risk events in detail. The examination is essential given the various types of operational risk events, which often occur independently, sometimes influenced by external factors. Thus, it is beneficial to analyze these events individually. Based on the findings, only events leading to physical damages occur with a higher likelihood in companies with elevated ESG scores. However, the severity of damages can be significantly mitigated by companies with strong ESG performance, especially those damages arising from improper business practices. The dissertation later shifts the lens to the investors, exploring how their past financial experiences influence their decisions regarding ESG investments. Motivated by the literature of behavioral economics and finance, we study with a portfolio approach, whether investors are willing to sacrifice more return for sustainability and responsibility when they face prior gains rather than facing prior losses. We find that a higher ESG score has a lower expected return for stocks with prior gains and there is no statistically significant relation for stocks with prior losses. Furthermore, pricing the responsibility aspects of companies is more likely the case of the naive investors who are sitting in gain. The mispricing due to responsibility investing exists among them only, those who are not able to move back the prices to equilibrium due to the limits of arbitrage. There may be effects of the green investors on the sophisticated market, but the brown capital market participants immediately trade these arbitrage opportunities. The behavior model of the house money effect accelerates when the investor sentiment is relatively positive. In these times, the market anomalies become stronger, and the limits of arbitrage get more expensive. In the case of sophisticated investors, ESG is not priced in any of the market moods. In high liquidity, the potential mispricing of ESG disappears, however, the improvement of illiquidity makes the trades of this arbitrage opportunity more expensive.