Stock Price Overreaction to ESG Controversies

There has been substantial growth in the incorporation of environmental, social and governance (ESG) issues into investment decisions, and this trend has been motivated by the societal benefits that are achieved when socially responsible firms have access to cheaper capital. While the benefits with ESG investing are apparent, we investigate the possible downside of the trend towards ESG by examining how this approach to investing might affect market efficiency. ESG is now a highly salient aspect of an investor’s information set and, given cognitive limitations, investors might devote substantial resources to examining ESG characteristics to the detriment of other firm fundamentals. Consistent with salience theory, we report that this over-emphasis on ESG results in the market overreacting to news about ESG controversies. This over-reaction is more pronounced within smaller firms and stocks that were held by more transient investors before the announcement. Contrarian investors are likely able to profit from the unpopular strategy of buying stocks after bad ESG news is released.