ESG Score, Scandal Probability, and Event Return

Will a high ESG rating firm suffers more stock market drawdown than a low ESG rating firm if an ESG scandal happens? We address this prediction theoretically and empirically. Using ESG scores from four mainstream rating agencies and ESG scandal data, we find higher ESG score is associated with lower ESG scandal probability but is also associated with more negative returns once the scandal happens. We also find higher ESG score disagreement between rating agencies is associated with lower scandal return. Based on our findings and a production-based CAPM model, we document that firm faces an optimization problem in determining an optimal ESG investment level, and the ESG preference level, firm initial reputation level, and firm size play key roles in determining the firm optimal ESG investment