Can Firms Be Both Profit and Purpose-Driven? An Empirical Analysis Using Environmental, Social, Governance (ESG) Scores and The Sharpe Ratio
Haverford College. Department of Economics
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This paper explores whether firms can do good while doing well. Given the explosive growth of literature with disparate findings on this topic, this analysis focuses on whether the relationship between profit and purpose is one of trade-off or complementarity. Using Environmental, Social, and Governance (ESG) scores and annual Sharpe ratios from Thomas Reuter Eikon, this study employs various firm and time fixed effects regressions to examine a potential causal relationship at the firm level. Since the average retail investor is not well-diversified, rather than focusing on abnormal returns (determined by deviations from CAPM expected return), this paper adopts the Sharpe ratio as a more realistic and comprehensive performance proxy. Furthermore, this paper isolates the three individual ESG dimensions and examines their effects on performance separately. Initial specifications find that ESG scores are positively correlated with the Sharpe ratio, with the governance score driving most of the positive changes. However, after normalizing Sharpe ratios with annual market average Sharpe ratios, ESG scores become negatively correlated with the Sharpe ratio, with the environmental score driving most of the negative changes. This suggests that perhaps firms cannot be both profit and purpose-driven. Companies face a trade-off between maximizing financial and non-financial purpose goals. Future research should focus on the causal mechanisms and channels of how ESG scores affect performance.