The Influence of ESG Ratings On Idiosyncratic Stock Risk: The Unrated, the Good, the Bad, and the Sinners

Abstract

This study analyzes whether stocks of companies with environmental social governance (ESG) rating show lower idiosyncratic risk. The main analysis covers 898,757 company-month observations of US stocks in the period from 1991 to 2018 and controls for stocks’ exposure to liquidity, mispricing, innovations in volatility risk, investor sentiment, and analysts’ forecast divergence. The main finding is that the receipt of an ESG rating decreases idiosyncratic stock risk. The effect is stronger for stocks that receive a higher ESG rating. Nevertheless, even when companies receive a lower ESG rating, they show significantly lower idiosyncratic risk than stocks without an ESG rating. Furthermore, stocks subject to a negative screen show lower idiosyncratic risk during recessions than comparable stocks with an ESG rating but without a negative screen. The results support the notion that the receipt of an ESG rating decreases uncertainty regarding future stock risk and return and show that ESG ratings and negative screens individually influence stock risk and, therefore, should be considered separately.

How to combine ESG scores? A proposal based on credit rating prediction

“…ESG behaviour and ESG disclosure can reduce the perceived riskiness of companies and hence the cost of capital. According to Horn (2023), ESG ratings reduce idiosyncratic risks and Giese et al (2019) further find that ESG information also reduces systematic risk. Further, Bax et al (2023) find that ESG risks are found to contribute to tail risks in portfolio construction.…”

Sustainability Management: A Review of ESG Principles and Policies in Investment

“…In addition, Horn and Glück have demonstrated that companies with good ESG performance, which are rewarded with rating upgrades, can effectively diminish downside risk, systematic risk, and idiosyncratic risk [26,27]. Nevertheless, the successful adoption of ESG necessitates gradual modifications and execution, including the elimination of greenwashing and the cessation of regulatory practises.…”

Gambling Behavior of Private Investors in Financial Markets : A Comprehensive Empirical Analysis

“…See also Section 3.4.5. 97 See Oehler et al (2016e), Wendt et al (2018), Horn andOehler et al (2022a). 98 See Oehler et al ( ), (2017d.…”

“…400 See, inter alia, Oehler et al (2011b), (2012a), ( 2014b), (2018e), and . In this regard, see also the literature assessing sin stocks (see Fabozzi 2017, Fabozzi et al 2008) and literature assessing environmental, social, and governance (ESG) firm ratings that aim at faciliating sustainability-based investment decisions (see Horn 2023.…”