Is ESG a Sideshow? ESG Perceptions, Investment, and Firms’ Financing Decisions

As investor interest in ESG (environmental, social, and governance) skyrocketed in the mid 2010s, ESG ratings became an important area of focus. A strong rating could mean greater inclusion in ESG focused funds (Hartzmark and Sussman, 2019), which in turn increases investor interest in owning a company’s stock due to its ESG properties. While ESG sometimes aligns with value creation, often it does not. In principle this suggests that firms attracting substantial interest from investors for reasons unrelated to the valuation of expected cash flows could issue equity more cheaply. What would we expect firms that received strong ESG ratings to do with this opportunity – and what did they in fact do?

Considerable research has shown that in many situations, firms respond to equity prices that might be overvalued relative to their fundamental value by issuing equity and investing the proceeds in capital (Baker, Stein, and Wurgler, 2003; Baker, 2009). However, the financial theory of frictionless markets (Modigliani and Miller, 1958) would say that a firm should only increase its investment in capital assets if it receives a positive NPV opportunity based on the opportunity cost of capital, a purely financial consideration related to the risk and return properties of the investment itself. An ability to raise money (whether via debt or equity) under favorable circumstances does not mean the firm should overpay for an asset (see Brealey and Myers, 1991; Brealey, Myers, and Allen, 2007).

In our paper Is ESG a Sideshow? ESG Perceptions, Investment, and Firms’ Financing Decisions, we find that controlling for fundamentals, firms do in fact enjoy higher valuation ratios in the form of Tobin’s Q when they receive higher ESG ratings. But firms do not respond to this by investing in fixed assets or R&D. Instead, they rebalance their capital structure, issuing equity to pay down debt. This is in fact what the frictionless model predicts – financially unconstrained firms are already taking all possible positive NPV projects; as such they should issue equity and reduce net debt. Baker and Wurlger (2002) demonstrate empirically that fluctuations in equity market valuations have large and persistent effects on capital structure, as firms exploit market timing opportunities to set their leverage.

If changes in investors’ perceptions about the ESG qualities of a firm shift the total available supply of investor capital to that firm, we would observe an increase in the firm’s overall capital, as long as its demand for capital is not completely inelastic. On the other hand, the opportunity cost of capital for a particular project should not be impacted by fluctuations in capital availability, implying no increase in firms’ assets. In fact, Berk and van Binsbergen (2025) find that ESG divestitures – given their current magnitude – are unlikely to have an impact on the cost of capital of the affected firms.

Investors’ perceptions about the ESG qualities of firms are largely shaped by ESG ratings published by professional ESG data providers. A growing body of research has raised questions about the consistency of ratings across providers and the retroactive changes or backfilling of these ratings (Berg, Fabisik, and Sautner, 2021; Berg, Kölbel, and Rigobon, 2022). To address such concerns, we develop a dataset based on point-in-time ESG ratings of a leading ratings provider, Refinitiv, ensuring that our analyses only consider ratings actually available to investors at the time they make financial decisions.

Given such time-consistent information on the ESG qualities of firms, we document that higher ESG ratings (particularly their environmental component) are followed by an increase in equity issuance and decrease in net debt issuance of similar magnitude. Firms exploit the valuation effects of ESG ratings to rebalance their capital structures towards equity and away from debt without changing their overall investment or capital structure. Our finding is consistent with an interpretation that ESG is essentially a sideshow for corporate investment, to borrow a term from the seminal paper by Morck, Shleifer, and Visnhy (1990). This is what is expected if ESG-rated firms are financially unconstrained and experience non-fundamental changes in the prices of their securities. These firms would take all positive NPV projects and exploit equity market fluctuations to make value-enhancing capital structure transactions.

To explore whether companies might intentionally improve their ESG ratings before issuing new shares, we look at how changes in ESG ratings often happen across entire industries—not just individual companies. We therefore focus on these industry-wide shifts, which are likely due to changes in how ratings are calculated rather than individual company actions. This helps us rule out the possibility that companies are simply adjusting their ESG reporting in anticipation of issuing new stock. By breaking ESG ratings down into two components – one that reflects trends across an entire industry and another that’s specific to each company – we find that companies’ capital structure adjustments are strongly influenced by the industry-wide changes. In fact, when Refinitiv updates ratings for whole groups of companies at once, the shifts in firms’ financing decisions are even more pronounced.

Valid inference hinges on ensuring a time-consistent information set, one that relies on ESG ratings that were actually available to investors at the time companies made financial decisions. We document false inferences about capital raising decisions of firms if the standard Refinitiv product were used instead of the point-in-time data. We find that restatements of past ESG ratings tend to occur for growing firms, so that using the standard Refinitiv product would lead to the incorrect inference that assets grow upon ESG rating upgrades. False inferences about asset growth are primarily driven by the fact that the coverage of the standard Refinitiv dataset extends rating histories back to time periods when investors did not have the information available in the scores.

Our findings are consistent with the hypothesis that changes in ESG scores neither affect a firm’s opportunity cost of capital for new investment projects nor relax financing constraints, although firms behave as if the changes in ESG ratings (particularly environmental scores) change the relative prices of issuing different types of securities. Our findings are not meant to imply that firm securities issuance in response to a supply shock never impact asset growth. However, in the setting of ESG, we find that while ESG upgrades raise firm valuation ratios, they do not lead to balance sheet growth. Rather, they lead to firms issuing equity to reduce net debt, pointing towards our interpretation that ESG is a sideshow for corporate investment.