Climate Change, Sustainability, and Financial Markets Exam 1 Review

True/False: According to Friedman a business should never do any social good even if that social good improves profits

False

The Friedman article invokes the "no taxation without representation" phrase because

A manager who is using shareholders/employees/customers money to do social good is acting as if they are taxing and allocating the proceeds without being democratically elected

According to the Friedman article, addressing social problems such as pollution is

The role of the government

True/False: According to the Friedman article, a manager must increase profits at all costs, but is a caveat that the manager should follow the law and ethical custom

True

True/False: According to Milton Friedman, the social responsibility of business is to increase profits

True

The Edmans paper primarily examines:

A. The effect of customer satisfaction of firm value

B. The effects of employee satisfaction on stock returns

C. The effects of employee satisfaction on firm profitability

B. The effects of employee satisfaction on stock returns

True/False: The Edmans paper finds that Socially Responsible Investing can never improve investor performance

False

The Edmans paper's main tests use data from:

A. The 100 best companies to work for in America 

B. Employee turnover disclosed in firm Annual Reports

C. Brand satisfaction data from AC Neilson

D. The 100 most profitable companies in America

A. The 100 best companies to work for in America 

The Edmans paper claims that it shows evidence of:

A. Market underreaction because stock prices do not immediately reflect data on customer satisfaction

B. Market overreaction because stock prices overreact to intangible information..

C. Market underreaction because stock prices do not immediately reflect data on employee satisfaction

D. Market efficiency because future returns eventually reflect intangible information

C. Market underreaction because stock prices do not immediately reflect data on employee satisfaction

The Edmans paper argues that suffers from fewer reverse causality concerns because:

A. The paper does not discuss reverse causality

B. It uses a regression discontinuity design methodology

C. More valuable firms do not do more ESG related activities

D. It uses future stock returns

D. It uses future stock returns

Conservation of the Natural World

Environmental

Consideration for People and Relationships

Social

Standards for Running a Company

Governance

What are some examples of “environmental”

• Climate change and carbon emissions

• Air and water pollution

• Biodiversity

• Deforestation

• Energy efficiency

• Waste management

• Water scarcity

What are some examples of “social”

• Customer satisfaction

• Data protection and privacy

• Gender and diversity

• Employee engagement

• Community relations

• Human rights

• Labor standards

What are some examples of governance

• Board composition

• Audit committee structure

• Bribery and corruption

• Executive compensation

• Lobbying

• Political contributions

• Whistleblower schemes

True/False: Climate risk is a systematic risk that affects the economy

True

True/False: Climate risks creates new winners and losers which is important for financial markets

True

True/False: Climate risk does not affect wealth (stocks, bonds, labor, real estate) of investors

False

True/False: Climate risk could bring about new regulation which impacts financial markets

True

True/False: Investors do not have preferences related to

avoiding climate risks

False

True/False: Financial markets are not important for climate risk

False

Stakeholder

Any group or individual impacted by or able to influence the company’s actions (e.g., employees, suppliers, customers, community, government). Concerned with corporate social responsibility, product quality, job security, or timely payments. Focuses on ensuring long-term sustainability.

Shareholder

Own equity in the company, holding direct financial interest and usually voting rights. Seek high ROI, dividends, and increased share price.

According to Freidman, who is an executive responsible to?

The owners (Shareholders)

What is Friedman’s definition of social responsibility

Doing something in the interest of society but not owners

How does Friedman define social good?

Anything that is not profit

True/False: Friedman believes that a corporate executive would be spending someone else’s money by doing the social good

True

Who does Friedman believe should perform actions to help the social good?

The governement

According to Friedman, what should be the focus of firms

To make the most profits to maximize shareholder value

True/False: According to Friedman, businesses have responsibility

False - only people have responsibility

Friedman believes social responsibility is a form of taxation without representation, explain:

When executives spend corporate money on social goals, they are effectively imposing “taxes” on shareholders, customers, or employees and deciding how to spend those funds.

True/False: Friedman believes if there is no difference in efficiency between individuals and corporations donating, corporations should not donate

True

What are the 3 main critiques of Friedman?

• Firms should maximize shareholder welfare not value

  • – Shareholder preferences matters

  • – Non-separability of firm actions and social good or bad

• Short-termism

• Inadequacy of government

What is the critique of maximizing shareholder welfare instead of value?

It could take away from minority shareholder who share different preferences than the majority

True/False: Hart and Zingales believe that individuals have preferences other than money, so shareholders should be allowed to have preferences other than money too

True

What is an example of the separability of charity and firm actions?

If a restaurant has extra food, spending money to donate the food would be much cheaper (and more efficient) than shareholders buying, cooking, and then donating food

True/False: Friedman is precise about what profits to maximize

False

Short-termism

This occurs when firms focus on share price and/or next-quarter earnings. Managers cut investments to make short-term goals.

True/False: Short-termism leads to suboptimal actions by managers

True: many firms hit their short-term targets by cutting things that hurt them in the long-run

Explain the inadqeucy of government crituqe of Friedman:

• Governments have not made much progress in tackling issues related to ESG

• Government rules and regulations are determined in consultation with corporations

  • Firms lobby the government

• After the Citizens United case, corporations can spend unlimited money on elections, dramatically increasing their influence

Business judgement rule

A common-law doctrine that protects corporate directors and officers from personal liability for business decisions, even if they result in losses, provided the decisions were made in good faith, with reasonable care, and in the best interests of the company

Shareholder Primacy

A corporate governance theory holding that shareholder interests should take priority over all other stakeholders, focusing on maximizing share price and wealth

Which 2 cases studied in class focus on the business judgment rule?

1. Dodge v Ford

2. Craigslist

What are the justifications for corporate social responsibility?

1. Corporate purpose results in greater long-term shareholder value

2. Grow the pie argument

3. Delegated Philanthropy

What is the “grow the pie” argument (from the TED Talk)?

It is motivated by building a better world. If you help people through innovation, profits will eventually come. The goal is to build things that ultimately generate shareholder value.

Delegated Philanthropy

A model where funders (individuals, corporations, or institutional investors) transfer the responsibility for designing and implementing social solutions to nonprofits, community groups, or specialized managers. It allows shareholder to express preferences

What are the concerns with delegated philanthropy?

insider initiated philanthropy or greenwashing

What are the concerns with the stakeholder approach to CSR?

• No clear guidance on the trade-offs of interest

• Shareholders hold managers accountable (US law only) and it may be hard to hold managers with multiple objectives accountable

What are some alternative methods to the stakeholder approach?

• Don’t register as a corporation or register as a benefit corporation

• Do something similar to the German model, where employees are required to hold seats on supervisory boards of firms

Value investing

investors invest in ESG for a lower risk, higher return, and to hedge climate risk

Values investing

Investing for non-pecuniary preferences. Investors are willing to sacrifice returns to invest in ESG.

Reverse Causality

Occurs when the presumed cause-and-effect relationship between two variables is flipped, meaning the supposed effect actually causes the supposed cause

Omitted variable

Occurs in statistical modeling when a relevant independent variable is excluded, causing the estimated coefficients of included variables to be biased and inconsistent. This happens when the omitted variable is both a determinant of the dependent variable and correlated with the included independent variable.

What did Edman’s hypothesis?

Employee satisfaction leads to higher returns

What was Edmans approach?

• “100 Best Companies to Work for in America’’ list

  • initially published in a book and then in Fortune every January

• Formed portfolios of the best 100 firms

Why did Edmans take the appraoch he did?

• The information on the top 100 places to work is public data (efficient market hypothesis)

• To try and eliminate reverse causality

What did Edmans find from his research?

His portfolio has excess returns of about 2.3% to 3.8% per year

over a period of 29 years (89% - 184% compounded)

What did Khan et al examine?

The effects of material sustainability investments

How did Khan et al examine the effects of material sustainability investments?

Examined

• MSCI KLD sustainability scores mapped to SASB (Sustainability Accounting Standards Board’s) materiality scores

• KLD provide scores on a) Community, b) Corporate Governance, c) Diversity, d) Employee Relations, e) Product, f) Environment, and g) Human Rights

• Generate a material sustainability ranking for each firm

What did Khan et al find?

• Firms with high material sustainability scores outperform those with low scores (deciles) by about 8.75% per year

• Results concentrated in firms with Low Performance on Immaterial Issues & High Performance on Material issues

Why did Khan et all take the approach they did?

1. Distinguishing Material from Immaterial ESG Factors

• Not all sustainability initiatives create equal value. By mapping KLD scores to SASB's materiality framework, they could identify which ESG factors actually matter financially for specific industries

• This addresses a key criticism of ESG investing: that blanket sustainability screens may include irrelevant factors that don't affect firm performance

2. Testing Market Efficiency Around ESG Information

• Similar to Edmans' approach with employee satisfaction, Khan et al. are testing whether the market fully prices sustainability information—specifically, whether it distinguishes between material and immaterial ESG factors

3. Resolving the ESG Performance Puzzle

• Their finding that returns are concentrated in firms with "Low Performance on Immaterial Issues & High Performance on Material Issues" is particularly revealing

• This suggests that firms strategically focusing resources on material sustainability factors (rather than spreading efforts across all ESG dimensions) generate superior returns

• It implies the market initially undervalued this focused approach, possibly because investors couldn't distinguish strategic ESG investment from unfocused "greenwashing"

What did Flammer examine?

Shareholder proposals

What approach did Flammer take?

A ‘regression discontinuity’ design

• Shareholder sponsored proposals that pass or fail by a small margin

Why did Flammer use a regression discontinuity design

No reason to expect any systematic difference between a

company for which a CSR proposal passes with 50.1% of the

votes one for which a similar proposal fails with 49.9

What did Flammer find

• The passage of close proposals leads to:

  • Announcement returns of 0.92%

  • Since 52% of accepted proposals are implemented this corresponds to a 1.77% increase in value

  • Most gains for firms with low levels of CSR

• Positive impact on operating performance

  • increase in labor productivity and sales growth

• Does not imply that any CSR proposal adds value

  • Close-call proposals differ from non close call proposals:

What do Gartenberg, Pratt, and Serafeim (2018) examine?

Purpose and performance

How do Gartenberg, Pratt, and Serafeim (2018) examine purpose and performance?

By using a survey by the Great Places to Work Institute:

• Calculate measures of purpose from 456,666 employees across 429 firms and six years

• Purpose measured from responses to:

  • “My work has special meaning: this is not just a job”; “I feel good about the ways we contribute to the community”; “When I look at what we accomplish, I feel a sense of pride”; and “I'm proud to tell others I work here

Why did Gartenberg, Pratt, and Serafeim (2018) examine purpose and performance?

Purpose is intangible and hard to measure

What did Gartenberg, Pratt, and Serafeim (2018) find?

• No difference in operating performance between high and low purpose firms

• Identify two types of high purpose firms

  • High Purpose-Camaraderie,

  • High Purpose Clarity

    • High purpose clarity firms exhibit superior operating and stock market performance

• Relation driven by middle managers and salaried professionals. No relationship for senior executives, sales or hourly workers

What are the two-types of high purpose firms What did Gartenberg, Pratt, and Serafeim (2018) indentified?

1. High Purpose Camaraderie (between workers)

2. High Purpose Clairty (from managers)

True/False: In Gartenberg, Pratt, and Serafeim (2018) study, high purpose firms were relation driven by senior executives

False: they were relation driven by middle management and salaried professionals

What did DellaVigna and Pollet (2007) examine?

Predictable changes in probability

• If Industry profitability is predictable based on cohort sizes

  • E.g. Large cohort in 2004 predicts school bus demand in 2010

How did DellaVigna and Pollet (2007) examine predictable changes in probability?

Through demographic shifts and how they affect profitability and stock returns in

different industries

What did DellaVigna and Pollet (2007) find?

• Industry profitability can be predicted

• Industry returns can be predicted!

• Trading strategy results in returns of 6% per year

• Works for long-term (>5 years) not short-term demand growth

• Caused by investor inattention (analysts typically forecast up to 5yrs)

True/False: DellaVigna and Pollet’s (2007) findings on industry predictions works for short-term demand and growth

False: works for long-term demand and growth (>5years)

True/False: According DellaVigna and Pollet (2007) markets are not efficient more than 5 years out

True: this is caused by investor inattention (especially to the long-term)

True/False: Flammer’s regression discontinuity design helps eliminate selection bias

True: her research is set up like a randomized control trial to help eliminate selection bias

In the context of Edman’s paper, what would be an example of reverse causality?

Instead of employee satisfaction at the 100 best firms to work for causing returns in the future, returns in the future at the 100 best firms to work for causes employee satisfaction

What is a potential omitted variable in Edmans’ study?

Industry association

What are the basic assumptions of portfolio theory?

Investors prefer higher returns and lower risk

True/False: Markets are reasonably efficient

True

True/False: if anywhere, you are likely to find performance in places that are long-term and material /relevant

True

Systematic Risk

Market risk - a risk that impacts the entire portfolio and is risk you have to bear

True/False: you get compensated by the market fir systematic risk

True

As compensated risk ______ (increases/decreases), expected returns _______ (increase/decrease) and price _______ (increases/decreases)

Increases, increases, decreases

or

Decreases, decreases, increases

True/False: Idiosyncratic can be diversified away

True: it is the risk you don’t bear

True/False: hedging climate risk is important to investors

True

Portfolio weights in climate hedge portfolios go ____ (up/down) with more negative correlation with other assets

They go up. The higher the negative correlation, the higher the wait will be. Inversely, climate hedge portfolios with a small negative correlation have less weight.

Why do we maximize the Sharpe Ratio?

Maximizing the Sharpe ratio allows investors to identify the portfolio that provides the highest expected return for the lowest possible volatility (risk), often referred to as the "tangency portfolio". It ensures that excess returns—those above the risk-free rate—are maximized relative to the risk taken.