**2. Literature review on ESG investments**

#### **2.1 ESG investment and equity markets**

#### *2.1.1 Positive implications of ESG investing*

Markowitz [2] has set a seminal framework of the modern portfolio theory (MPT) in how investment decision can be made based on the risk and return trade-off. Even though MPT was introduced more than 60 years ago, it is still an important foundation in the financial world until today. MPT allows investors to make investment and asset allocation decision by considering the rates of return, volatility, and importantly how the assets' returns move together. An important implication of MPT is that the volatility of the portfolio of multiple assets generally would be smaller than those of individual assets combined through diversification. On the other hand, the exact impacts of ESG information on financial performance are still unclear, and the findings about the relationship between ESG information and investment performance are still inconclusive [3]. It has long been a debate as to whether socially responsible investing and ESG information have any effects on risk and return trade-off and importantly on diversification.

Specifically, market participants are also interested to know whether ESG information would be transmitted to the companies' stock prices and their performance. Gasser et al. [4], based on Markowitz's portfolio selection theory, propose a modified model that incorporates a social responsibility measure into the analysis. By examining more than 6000 international companies including stocks that are rated relative to the social responsibility criteria, they find that when investors' objective is to maximize the social impact of their investments, the expected returns are statistically and significantly lower. However, when the portfolio is optimized relative to the social responsibility and risk, it yields a higher social responsibility rating than the portfolio that is optimized relative to just the risk and return. Several studies have also found positive effects of ESG investment on portfolio's return (e.g., see [5–7]). In particular, Ashwin Kumar et al. [8] examined 157 listed and 809 non-listed companies on the

#### *Perspective Chapter: The Environmental, Social, and Governance (ESG) Investment and Its… DOI: http://dx.doi.org/10.5772/intechopen.108381*

Dow Jones Sustainability Index. They find that for companies that incorporated ESG factors, their stock performances exhibit lower uncertainty, while at the same time provide higher returns. The finding demonstrates that efficient investment strategies could be obtained for stocks that have high ESG performance.

Even though we have witnessed tremendous amounts of fund flows into sustainable investment assets in recent years, the proportions of sustainable investing, however, are still concentrated in developed markets such as in the European and the US markets. The proportions of sustainable investing assets in the emerging markets are still significantly smaller [9]. An interesting question is whether the risk and return trade-off, and corporate performance, especially in developing markets, can be enhanced with ESG factors over the conventional investment portfolio is of interests to both corporates and investors. In China, evidence suggests that financial performance can be improved with positive ESG factors (e.g., see [10, 11]). Several studies find that ESG investing in China can beat the market portfolio, and that the risk-adjusted returns are higher for ESG equity index portfolios relative to the reference market indices [12]. Deng and Cheng [13] find similar results. By examining China's A-share listed companies, they find a positive relationship between the improvement of the ESG indices and stock prices' performance. In particular, they find that there is a greater influence of ESG indices on non-state-owned enterprises than for state-owned enterprises. In addition, the ESG factors affect the market values of companies in secondary industry (i.e., processing and manufacturing related) more than that of the tertiary industry (i.e., service industry).

In other emerging economies, Rehman et al. [14] study the integration between ESG and composite indices in Brazil, Russia, India, China, and South Africa, or the so-called BRICS countries. They find that ESG indices are integrated with (equity) indices in BRICS countries. In addition, they observe short-run causality between conventional and ESG equity indices only in Brazil and Russia. On the other hand, a long-run causality between conventional and ESG equity indices exists in the Indian market. Specifically, they find that MSCI ESG equity indices in individual countries show a long-run causality with MSCI composite equity indices of all other BRICS counties, suggesting a flow of information between conventional and non-conventional (ESG) markets across these countries. Sherwood and Pollard [15] analyze MSCI Emerging Markets ESG Indices and non-ESG MSCI Emerging Markets Indices from 2007 to 2016 and find that investments with ESG integration provide significant superior performance. Their findings suggest that ESG emerging market equities could provide investment opportunity for higher returns and lower downside risk than comparable non-ESG equity investments.

ESG investing exhibits positive characteristics during turbulent markets such as during the COVID-19 market shock [16]. Looking back to the year 2020, the market experienced anxiety and uncertainty due to the coronavirus outbreak, and declined, between February and March 2020, by more than 30%. Using Chinese stock market data, Broadstock et al. [17] show that equity portfolio with high ESG performance tends to perform better than low ESG performance portfolio. In addition, they also find that ESG equity portfolio can alleviate financial risk, and this risk mitigation characteristic of ESG portfolio is essentially more pronounced during a financial crisis, such as the COVID-19 market shock. Not only that, during the COVID-19 crisis, evidence from a fund-flow analysis shows that investors preferred to invest in low-ESG risk investments, suggesting that ESG investment is a preferred hedging strategy during turbulent markets [18]. Engelhardt et al. [19] find similar evidence in Europe, where European firms with high ESG ratings exhibited higher abnormal returns and lower stock volatility during the COVID-19 crisis.

Pedersen et al. [20] suggest that ESG factor can also be incorporated into the efficient-frontier portfolio framework allowing investors to weight in the cost and benefit of ESG investing. Their analysis shows that there are benefits of ESG information. The risk-adjusted return, i.e., Sharpe ratio, can be enhanced through the so-called ESG-efficient frontier. They find that for a high level of ESG proxy, the Sharpe ratio can be optimized. However, investors can pay a small cost as in a drop in the Sharpe ratio in order to obtain a higher ESG level. They imply that "ethical goals can be achieved at a small cost." The main question remains. What should investors do when they want to do good and also to perform well with their investment? Cornell and Damodaran [21] suggest that the important factor for an investment success with an ESG focus is to invest in companies that do good before that is priced into the stock price. Otherwise, as evidence has shown, investing in firms that are already known by the market as good firms tends to reduce investor returns. Taken together, this can be implied that because investors demand to invest in good firms, the stock prices are expensive, thus putting a pressure on the returns. To increase firm value through ESG factors, the implemented ESG strategies and actions must yield higher cash flows or lower the uncertainly or both [21]. In addition, it has been shown that there are several factors that affect the ESG information and investment performance, including the type of the industry and the regional differences [22]. Besides, it is important for investors to consider the changes in ESG ratings when making investment decisions since they also affect returns. Despite the fact that increases in ESG rating may lead to positive (although inconsistently and small) abnormal returns, the ESG rating downgrades yield statistically significant negative risk-adjusted returns [23].

Taken together, the evidence from both developed and developing economies suggests that ESG investing may have positive relationship with returns and negative relationship with uncertainty, especially during a period of financial crisis. These are two important beneficial characteristics of ESG information on investments.

Although there have been several studies that examine the relationship between ESG investing and financial performance and found positive results, yet there are also evidences that suggest the conclusions are still premature. In the next section, we will examine studies that find contradictory results regarding ESG investing.

#### *2.1.2 Contradicting findings on ESG investing*

In contrast to the positive evidence of ESG investing discussed earlier, several studies, on the other hand, have documented some weaker or even contradicting results. Recently, La Torre et al. [24] examine the performance of Eurostoxx50 companies relative to their ESG commitments. They find that even though there exists a (positive) correlation between the ESG index and stock returns, the relationship is rather weak and also varies from company to company. Although the positive effect of ESG factors has also been found in certain sectors, such as energy and utility, this evidence could rather be explained by their ESG investments, which play a significant role for the sectors' profitability. It has been argued that investors, generally, follow the investment criteria in which corporate financial performance can be assessed through traditional financial variables such as EBITDA and leverage measures. Several studies also find limited relationship between ESG investing and stock performance in specific markets. For example, Landi and Sciarelli [25] examine Italian blue-chip firms and find no significant relationship between ESG assessment and abnormal returns. This can be implied that investors do not incorporate corporate sustainability and social responsibility as a factor in their stock selection process.

#### *Perspective Chapter: The Environmental, Social, and Governance (ESG) Investment and Its… DOI: http://dx.doi.org/10.5772/intechopen.108381*

They conclude that for Italian blue-chip firms that deploy an ESG corporate strategy, social responsibility should not be considered a reliable financial leverage since there is no relationship between abnormal returns and ESG rating.

It has been suggested that the negative relationship between ESG rating and firm performance may be because of the investment costs required for firms to undertake such ESG activities. Ruan and Liu [26] point out in their study that the firm performance drops by 4.3% for each one level increase in ESG rating of China: Shanghai and Shenzhen A-share, listed companies. Relative to state-owned enterprises, nonstate-owned enterprises, especially those that are non-environmentally sensitive companies, face a greater cost pressure on ESG activities. The differences in these enterprises and industry characteristics reflect the discrepancy of ESG cost pressures and thus affect the firm performance differently. In addition, it has been documented that the governance factor, such as board size, independence, and gender diversity, are connected to Chinese enterprises' environmental performance [27]. However, the impact of ESG policies, whether it is a positive or a negative one, may depend on specific geographical locations and industrial specifications. Constantinescu [28] finds that for the selected European companies, only companies in the energy sector exhibit negative correlation between the environmental factor and firm value. On the other hand, there is no significant relationship between the sustainability disclosure and the firm value for companies in the healthcare sector. Similarly, Buallay [29] finds that there is a negative relationship between ESG activities and financial performance in the banking section. Some, however, argue that ESG activities are costs that affect the profits and shareholders wealth, and thus there is no significant impact of ESG disclosure on firm performance, especially in environments in which information asymmetries are significant [30].

In terms of valuation, the firm value is the discounted value of all future cash flows. If everything else remains constant, a lower cost of capital would have a positive effect on the firm valuation. On the other hand, a higher cost of capital would have the opposite effect. A line of research focuses on the effects of ESG activities and the cost of capital. Atan et al. [31], for example, analyze Bloomberg's ESG database during the period between 2010 and 2013 and find that although the combined ESG factor positively affects the cost of capital, there is no relationship between individual ESG factors and the cost of capital. In addition, they find that the combined ESG factors have no impact on the firm profitability and firm value. Similarly, it has been found that environmental disclosure, on the other hand, increases the cost of capital for small and medium-sized enterprises (SMEs). This may be due to the fact that, in contrary to large corporations, SMEs face unique challenges of their own such as limited resources and their ability to access the capital requirements [32].

Giese et al. [33] focus on the relationship between ESG criteria and firm performance and value. Specifically, relative to the ESG information, they examine the firm performance and value through three different channels: (1) a standard discount cash-flow model, (2) the idiosyncratic risk, and (3) the firm valuation. The results show that there are linkage and information transformation of ESG data to the firm performance and value. Firms with improved ESG rating generally will experience a lower systematic risk, resulting in a lower cost of capital and thus a higher firm value. On the other hand, a higher ESG-rated firms often experience a lower firmspecific incident, i.e., a lower idiosyncratic risk. They conclude that "the transmission from ESG characteristics to financial value is a multi-channel process, as opposed to factor investing in which the transmission mechanism is typically simpler and one dimensional."

We have covered different views regarding ESG investing and its implications. The evidence, thus far, could be used to assist investors and corporates to make their investment decision and to design their ESG strategies and policies. The next section will turn to focus on the implications of ESG investing in another market setting, i.e., the fixed income markets.

#### **2.2 ESG investing and its implications: fixed-income markets**

In the past decade, there has been a significant interest and demand to invest in sustainable bonds. Several well-known companies, such as Apple and Alphabet, have issued ESG bonds to finance their green and environmentally concerned projects. According to Reuters report on December 23, 2021, global sustainable bonds issuance hits a record high in 2021 with issuance value totaled more than \$850 billion or approximately a 60% increase from 2020. An interesting question is how ESG characteristic in fixed-income markets add value to market participants. A study by Polbennikov et al. [34] finds that credit spreads tend to be lower for high ESG-rated bonds; in addition, these bonds also outperform their lower-rated peers. At the country level, it has been found that above and beyond financial ratings, high ESG ratings on sovereign bonds lower the country's borrowing costs [35]. In other settings, ESG ratings also show to have effects on the bond uncertainty. For example, Bahra and Thukral [36] find that ESG information can be used to improve portfolio characteristics such as lowering drawdowns, reducing volatility, and increasing risk-adjusted returns, even though the increase is marginal. Mendiratta et al. [37] find similar results regarding the relationship between ESG information and bond uncertainty. They show that ESG characteristics supplement credit ratings and provide further insights into bonds' risk and returns. Specifically, ESG information is more relevant to bonds with lower credit ratings and to bonds with longer maturities. In addition, ESG information is shown to be negatively correlated with the bond default rate [38].

It has also been found that ESG factors may provide certain benefits during market shocks. Evidence has shown that during a turbulent market, such as the COVID-19 shock in 2020, the correlation between ESG high-yield bond ETFs and conventional high-yield bonds decline, suggesting a potential risk reduction and hedging benefits between the two asset groups [39]. It can be implied that ESG high-yield bonds can be an effective hedging instrument for conventional high-yield bond investments. In addition, ESG high-yield bonds also provided higher returns relative to the comparable conventional high-yield bonds [39]. Naeem et al. [40] find similar evidence that during the market stress, such as the COVID-19 market shock, green bonds provide significant diversification benefits and are able to absorb the turbulent of market downfall. This is also consistent with the evidence that during the COVID-19 pandemic, there were investment preferences in ESG leaders in investment grade bonds over ESG leaders in the equity and high-yield bond markets [41].

The implications of ESG information can also be evaluated through the risk characteristics of the bonds by analyzing the performance of the bonds that have gone through credit rating changes, especially those that have been downgraded. One type of such bonds in particular is angel bonds, which are investment grade bonds that have been downgraded to high-yield bonds. Kumar and Khasnis [42] find that although, in general, higher price pressure due to higher yields and higher probability of bankruptcy are some certain characteristics of fallen angel bonds, ESG-fallen angel bonds nullify some of those negative characteristics and, on the other hand, increase the portfolio's risk-adjusted returns.

#### *Perspective Chapter: The Environmental, Social, and Governance (ESG) Investment and Its… DOI: http://dx.doi.org/10.5772/intechopen.108381*

Investors also need to be aware that variation in ESG ratings also has impacts on bond characteristics, especially on the bond valuation. Immel et al. [43] analyze green bonds, in which the raised capital is used for projects with climate and environmental benefits. They find that green bonds have a negative premium between 8 and 14 basis points. In addition, there also exists the influence of ESG factors on bond spreads. They show that a one-point increase in the ESG score results in a decline in the spread between 6 and 13 basis points. Other studies find similar, although smaller, negative yield premiums in green bonds and suggest that those negative yield premiums are not large enough to disincentivize investors to invest in green bonds [44]. However, the negative yield premiums in green bonds are not present equally across all types of issuers. For example, evidence shows that green bonds issued by financial institutions provide no yield differential relative to similar non-green bonds [45].

From the above evidence, we have already seen the implications of sustainable or ESG bonds on the risk and return characteristics of the bond itself. Another important dimension of sustainable or ESG bond issuances is its implications on the firm value and especially to the shareholders. Over the past several years, there have been issuances of ESG, especially green bonds worldwide. Many corporations raised capital with green bonds as a way to communicate and signal to the market that they care about the world, and the raised capital would be used in climate-friendly projects. Generally, when firms issue green bonds, stock prices often react positively and the stock liquidity also improves [46]. The cumulative abnormal returns are positive and significant after the green bond issuance announcements [47]. Not only that, the firm's ownership structure also tends to change. For example, after green bond issuance, the proportions of institutional and green ownerships increase [44, 46].

As we have already seen that sustainable and ESG investing have several implications to both equity and fixed-income market, the next section will address existing evidence regarding sustainable and ESG investing in the alternative investment markets.

#### **2.3 ESG investing and its implications: alternative investment market**

In this section, we will explore the implications of ESG investing in the alternative investment market such as real estate and private equity (PE). Alternative assets have been a valuable component of a well-diversified portfolio. With a much interest in sustainability and ESG information, investors have turned to focus on the sustainable and ESG components in alternative investment markets. Evidence suggests that ESG scores do have an impact on REIT performance. Aroul et al. [48] find that there is a positive relationship between ESG scores and REIT's operational efficiency and performance. In particular, REITs with high operational efficiency exhibit stronger the relationship between ESG score and operational performance. This is evidence that REITs can improve its value through ESG factors. Eichholtz [49] shows that higher ESG performance leads to narrower REIT bond spreads, the lowering the cost of debt for REITs. This in turn may suggest that there is a positive effect between REIT's uncertainty and income and sustainability practices. In addition, there is also a positive correlation between REITs with high ESG performance and firm value during a period of heightened market uncertainty. Feng [50] finds that in addition to having lower cost of debt, gaining better access to the capital markets, and displaying better financial flexibility, REITs with high ESG disclosure statically have higher market value during a period of market shock, such as during the COVID-19 pandemic. As with other types of entity, managerial issues, such as management

overconfidence, have shown to play an important role in firm performance. For REITs, research suggests that REITs with high corporate governance (G), managerial overconfidence do not have a profound effect on REIT's investment activities [51]. Although there has been evidence of a positive relationship between the ESG information and REITs' characteristics, these positive ESG implications may come with a cost. Studies find that investors often pay premiums in order to access companies with higher ESG ratings, and there is a negative association between overall ESG ratings and returns [52, 53].

Private markets, especially private equity (PE) have received a lot of interests from market participants in the past decade. According to Forbes report on July 8, 2021, PE assets under management are expected to reach \$5.8 trillion by 2025. In addition, ESG factors have been increasing incorporated into PE firms' investment strategies. Although it has been evidenced that PE firms exercise ESG factors into investment strategies, mainly as a risk management tool, Zaccone and Pedrini [54] point out that there is still an available dominant for PE firms to enhance their value creations through the integration of ESG factors into their investment decisions. One of such examples was illustrated by Indahl and Jacobsen [55]. Using the case of a Nordic PE firm, they show that the PE firm was able to stand out from its competitors and enhance its financial performance through the integration of ESG approach with their strategies. Although it should be noted that while positive ESG factors have potential to improve financial performance, ignoring responsible policies, or even worse, having irresponsible practices could reduce the firm price even by a larger percentage [56]. In contrary to a prior belief that PE and other shorter investment horizon institutional investors often overlook CSR (corporate social responsibility) and ESG values, it has been found that firm value can be improved with the integration of long-term sustainability supported by CSR in the PE segment [57]. In addition, the benefits of CSR implementation, along with corporate governance (G) policies by PE firms, can be transmitted in the form of financial value onto their investee companies [57]. Specifically, corporate governance (G) has been one important factor that drives PE firms' investment decisions. PE often searches for corporate governance improvement opportunities and invests in firms where the improved alignment between manager and shareholder interests can create financial performance and value [58].

Although the implications of ESG investing have been examined extensively, several studies find that ESG investing provides positive effects to both investors and corporations (e.g., see [8, 13, 15]), but other studies have found contradicting results (e.g., see [25, 26, 28]). Like other empirical studies, the contradicting implications of EGS investing may be due to the differences in the sample selections, time period of the analyses, and methodologies employed. To address these contradictory findings, the next section will try to identify the causes, the effects, and propose some plausible remedies to future research in ESG investments.
