ESG transparency and the decline of investment efficiency

What is the business of business? Is it merely to make a profit, or do companies have a social obligation that goes beyond the bottom line? It’s a question as old as the market and as fresh as today’s headlines, as companies face pressure to make their position on social issues as clear as the price on their product.

Environmental, social and governance investing, or ESG, has become a hot topic. And, increasingly government agencies are entering the discussion, with the SEC pursuing new standards for reporting non-financial information. But could this new push for improved ESG transparency have negative consequences for the companies that provide it? According to Gies assistant professor Yifei Lu, the answer is “yes.”

To explore the topic, Lu analyzed over 20 years of ESG reporting and the investment efficiency of the companies that reported it. And he spotted an interesting trend.

“What I find is that a firm’s investment efficiency drops when ESG is available to market participants,” says Lu, who offers two key theories to explain the phenomenon. The first, which perhaps seems counterintuitive, is that more information isn’t always a good thing.

“When non-financial information comes into the market, it crowds out financial information from the stock prices,” explains Lu, who says that managers often use stock prices to guide their investment decisions. Instead of adding clarity, an abundance of non-financial information merely muddies the waters. According to Lu, this causes reduced managerial learning, which leads to less efficient investing.

The second problem is that managers’ incentives can become less aligned with improving shareholder value when ESG data enters the picture. When stock price is the primary measure of success, managers invest their resources in the projects that will yield the best return. But when shareholders with strong ESG preferences place pressure on management, they may invest in social projects that are expensive and add little to the bottom line.

In his study, “Environmental, Social and Governance (ESG) Transparency and Investment Efficiency,” Lu found that this drop in investment efficiency was even more pronounced in firms with more initial ESG fund ownership and those with a larger increase in ESG fund ownership. Those with poorer initial ESG performance also appeared to experience less investment efficiency as they struggled to improve their performance in those areas.

Lu enjoys projects that involve interdisciplinary research and diving deep into topics that fall outside of traditional accounting, like ESG. In a study of managerial labor market competition, for example, he used network analysis from mathematics and the computer science discipline. And in another project, he explored how geopolitical tensions impacted foreign investment in China’s stock market using textual analysis of various government and media sources — including President Trump’s frequent tweets.

Lu, who studied mathematical economics in China, completed both a master’s and PhD in business administration at the University of Rochester in New York, where his research interested expanded to include other topics, like managerial learning and executive compensation. Ultimately, it was Lu’s passion for research in all these areas that brought him to Gies.

“I like the research environment here,” says Lu, who was impressed both by the size of the faculty and the scope of their work. “There’s a very large group of people doing all kinds of work.” And for Lu that opens the door to exciting possibilities.

“A lot of research is generated through talking to people from different disciplines,” says Lu. “That’s how textual analysis in accounting starts. People in accounting may see something interesting in computer science and apply it to accounting research.” That interdisciplinary exchange appeals to Lu, who looks forward to sharing his research and receiving feedback from colleagues in different fields who are just as passionate about their work.

But Lu isn’t just interested in research for research’s sake. As a teacher, he’s eager to take what he learns into the classroom, where it can be absorbed by the next generation of business leaders. “I think it’s important that we bring knowledge that we generate through research into the classroom,” says Lu. Facts and figures are great, but Lu wants his students to go beyond what they read in the textbook. “I want them to understand how business works based on evidence drawn from rigorous scientific studies.”