When it comes to pursuing a social purpose, companies need not only do good in the world, but they must be seen to be doing right by societal stakeholders if the are to impress investors.

That’s the conclusion after a team of researchers asked whether good behaviour in a company’s activities is actually meaningful, or “material” to other organisations like investors.

The answer is yes, but only if the good behaviour is measured and verified by well-known ESG ratings agencies.

The team—from universities in the UK, the Netherlands and Greece—looked at 1,856 US IPOs between 2007 and 2018. They conclude that companies with high ESG performance ratings before they go public on stock markets are more likely to be underpriced at launch. That results in “higher abnormal” returns after flotation; use of IPO proceeds for “real investment and debt redemption” rather than stockpiling; and better long-term financial performance.

The team concludes that companies with ESG ratings before flotation attract investors “who are financially sophisticated and characterised by long-term orientation”. And in simple terms, those asset managers “invest in ESG-rated firms based on firms’ potential rather than on sentiment”.

But the critical element is seeking ESG validation through the use of established ratings before going public. “This study,” writes the team, “robustly documents that firms have strong incentives to do good by serving a social purpose, as they not only perform financially well but they also attract financially sophisticated investors with long-term orientation.

“What is important, however, is not only to do good, by engaging in ESG activities, but also to look good by becoming visible to investors and other stakeholders through external rating of their ESG activities.”

ESG ratings and policies

The team believes important policy implications follow from their findings. Firstly, the findings justify the work of organisations such as PRI (Principles for Responsible Investment) that encourage investors to seek out companies with a good ESG record.

As a result of the pandemic, boards can also expect investors to demand that companies “reevaluate their ESG risk management and rebuild internal policies and procedures to anticipate future black swan events.”

But more important for events in US, legislation that makes ESG disclosures mandatory “could not only contribute to an inclusive culture within companies but, also, as our results have shown, to achieve firms’ economic objectives and ultimately increase shareholder wealth without harming stakeholder values and well-being.”

The imposition of mandatory ESG reporting remains a live issue in the US. One of the first actions after the election of Joe Biden as president was the launch of consultation by the Securities and Exchange Commission on the introduction of mandatory ESG reporting. Some big name companies, such as BlackRock and Apple, have called for the introduction of TCFD (Task Force on Climate-related Financial Disclosures) reporting.

Meanwhile, there is opposition to forced ESG reporting. One law professor, Amanda Rose of Vanderbilt University, writes that the “vagueness” of ESG definitions makes it difficult to identify the most important issues.

Though TCFD is becoming mandatory in the UK, the government has also pledged to use a new reporting framework under development by the International Sustainability Standards Board, launched during COP26 last month.

In Europe the EU is pushing ahead with an update to existing reporting rules through the Corporate Sustainability Reporting Directive, though the legislation is yet to receive final approval.

Sustainability or ESG reporting is viewed a key tool in tackling climate change. Governments are increasingly inclined to make them mandatory. That gives companies a huge challenge. This latest research showing that a good ESG performance may pay off with greater investor interest will be welcome news.