Lecture Notes (Part 1 - Part 17) Incl. Mandatory Papers!: Sustainable Finance & Value Creation (323081-M-6)

How to measure the success of sustainability disclosure and which problems arise?

Antwoord: There are 3 possible measures to measure the success. These are, (1) firms’ ESG activities and policies, (2) ESG performance (for example employee satisfaction, resource consumption, emissions, etc.), and (3) Financial performance of the firms. The problems are (1) the voluntary nature leads to high correlation between the reporting and the activities, (2) independent measurement is needed because of impaired objectivity, and (3) negative impacts on firm outcomes not necessarily imply beneficial impacts on stakeholders.

What are known problems with ESG ratings? How do investors deal with these problems? And what can be the underlying causes of the ESG rating divergence?

Antwoord: ESG ratings across different raters do not have much correlation as credit ratings of different raters have. Rating agencies use different measures and topics to establish their overall ratings. Investors deal with this information by mainly using just raw data and not the aggregated ESG scores. The underlying cause of ESG rating divergence is the way rating agencies measure the aggregated ESG scores. Also the purpose of their ratings plays a role. Some sustain these ratings for investor purposes, others to put a number on the ‘CSR risk’ of the company and there are many more purposes. This leads to different definitions of the same topic, because they are looked at from different viewpoints.

Explain how disclosure can affect disagreement.

Antwoord: Normally, one would assume, the more is disclosed the less disagreement exists on certain topics. However, this is not the case for CSR (ESG) disclosure. When companies decide to disclose more information on their CSR performance, they have to come up with their own chosen topics and ways to measure their progress. Competitors and other companies may choose to measure these same topics in a totally different way, which increases the disagreement even more. Rating agencies have to take more topics into account and find ways to integrate these in their ratings. Each agency does this in its own way, which will increase the divergence and therefore the disagreement.

A high ESG score is correlated with a higher cost of equity capital because CSR investments create value and therefore the shareholder receive a higher return. Is this statement correct or not? Explain in detail why or why not.

Antwoord: This statement is incorrect, because out of equilibrium this statement could be true: CSR is hyped up and increases returns to shareholders. However, when we return to equilibrium, the returns will lower, the price will lower and eventually the cost of equity capital decreases. A higher ESG score gives a signal of less risk, the asset is ‘safer’, which in equilibrium relates to a lower return and thus a lower CoE.

What is the sustainability wage gap? a) Employees of firms with a low sustainability (ESG) score receive a lower salary, which explains the lower S-score of these firms b) Employees of firms with high sustainability (ESG) score receive a lower salary because a lower salary is compensated by working for a sustainable employer c) Employees of firms with a high sustainability score receive a higher salary because such firms have a higher engagement with their employees, which is why employees like to work for a firm with a high sustainability score d) Employees of firms with high and low sustainability score receive similar wages but employees prefer to work in the firms with a high sustainability score because these employers provide more social benefits and the corporate sustainability goal provide strong incentives to employees.

Antwoord: b) Employees of firms with high sustainability (ESG) score receive a lower salary because a lower salary is compensated by working for a sustainable employer

Explain step by step the process of activism by SRI funds.

Antwoord: First, the activists take an equity stake in the firm and let an independent team identify problems and weaknesses of the firm. The activists can then determine goals and a success threshold. Second, the activists will contact the company: for a questionnaire about certain production processes for example. The activists may hold additional analysis and make additional contact, if needed. The activist puts pressure on the firm to improve certain aspects they had contact about. Finally, there’s the evaluation and closure of the activist process. They have an analysis of the outcomes, relative to the goals determined in the first step. If these have been achieved, the case is closed successfully.

Does SRI fund activism have an impact on the financial CSR performance of firms targeted in relation to E, S, or G issues?

Antwoord: SRI fund activism does not have a significant effect on accounting performance measures of the targeted firms. However, the authors find that ESG ratings are significantly adjusted following the targeting and that these firms’ buy-and-hold returns are increased, no matter the outcome. Especially successfully closed cases experience an increase in BHRs, they have 5% higher returns than the unsuccessfully closed cases.

Which of the following statements does not include an incorrect element? a. As a consequence of SRI fund activism, there is no material change in accounting and operating performance, and there are no significant buy-and-hold returns or cumulative abnormal returns. Still, activism positively affect the ESG performance of targeted firms. b. As a consequence of SRI fund activism, there is no material change in accounting and operating performance, and there are no significant buy-and-hold returns or cumulative abnormal returns. Still activism positively affect the ESG performance of targeted firms but mainly for those firms with poor ex ante ESG performance. c. SRI fund activism affect the ESG performance of targeted firms: after being engaged by the activist, firms with low ex ante ESG performance experience an increase in ESG performance while the ESG performance of those with high ex ante ESG performance is not affected. In addition, the buy-and-hold returns of engaged firms are significantly positive whereas there is no positive effect on accounting performance.

Antwoord: c. SRI fund activism affect the ESG performance of targeted firms: after being engaged by the activist, firms with low ex ante ESG performance experience an increase in ESG performance while the ESG performance of those with high ex ante ESG performance is not affected. In addition, the buy-and-hold returns of engaged firms are significantly positive whereas there is no positive effect on accounting performance.

Why do some firms that make charitable donations use a foundation?

Antwoord: Some firms use foundations, to move the decision-making process to an independent party. This decision-making is about the discussion to which causes the firm will donate and which not. To use a foundation, the management is not included in this process, which prevents donating to pet-projects or other personal interests (such as sponsoring the local golf association).

2. Which arguments support the use of M&A to help investigate a causal effect of bank ESG on borrower ESG? - M&A transactions create considerable attention by a variety of critical shareholders. - M&A transactions in the banking relationships lead to a shock in bank ESG. - M&A transaction in the banking industry are random. - M&A transactions in the banking industry are largely driven by regulatory, technological and competitive changes, likely exogenous to existing lending relationships. - M&A transactions in the banking industry are increasingly seen through an ESG lens.

Antwoord: - M&A transactions in the banking relationships lead to a shock in bank ESG. - M&A transactions in the banking industry are largely driven by regulatory, technological and competitive changes, likely exogenous to existing lending relationships.