ESG (environmental, social, and governance) investing is becoming increasingly important and widespread .and more than three-quarters of consumers report that they care about a sustainable lifestyle.
Consumers and investors rely on companies’ claims about their ESG practices – and that raises questions about how to evaluate the accuracy of those claims. Are they merely an exercise in virtue signaling that does not necessarily produce the promised progress?
A new paper, forthcoming in the Journal of Accounting Research, sheds light on the existence of this virtue signalling, finding evidence of “diversity washing.” Diversity washing is defined as the disconnect between companies’ external commitments to diversity, equity, and inclusion (DEI) and their actual underlying employee diversity.
The five researchers – Andrew Baker (Berkeley), David Larcker (Stanford), Charles McClure (Chicago), Durgesh Saraph (Jump Trading) & Edward Watts (Yale) — searched through disclosures about commitments to diversity in three different types of SEC filings for “nearly all U.S. public corporations” during the period of 2008 through 2021. They used a number of terms related to DEI to develop their database. The authors then compared the disclosures with data measuring the companies’ actual employee diversity.
The study makes a number of important findings.
First, it found an increase in the frequency of DEI keywords. While it counted about 5,000 such words in 2007, the number gradually increased, rising to approximately 12,500 in 2020, and almost doubling to close to 25,000 in 2021 (fig. 2). While the frequency of terms like “pay equity” did not change much, the study found large increases in terms relating to “ethnic diversity,” such as “racial” and “board diversity.” The study also found an increase in discussion of “corporate governance” and inclusive workplaces.
Second, it did find a positive, but weak, relationship between the number of DEI words in the firms’ financial disclosures and the percentage of both non-white employees and female employees. Digging deeper, however, the study found that many firms that ranked high in DEI discussions did not rank as highly on the diversity of their workforces . The researchers then analyzed which companies were more likely to engage in such diversity washing, finding that diversity washers tended to be larger firms that were “less profitable, have lower returns, and have higher book-to-market [ratios] and volatility.” As an explanation, the researchers suggest that these firms may be using “diversity discussion to shift the focus away from their worsening financial condition.”
Further analysis of the companies also showed that there was a positive relationship between the firms identified as diversity washers and the likelihood of having an EEOC violation. Moreover, these firms were also more likely to have a “questionable ESG policy.”
The authors observe that, while diversity washing firms might claim that their language was aspirational, there was little substantive change in subsequent hiring practices.
Nonetheless, investors rewarded these firms with “opportunistic ESG profiles.”
The study has important lessons: firms’ ESG rhetoric may not match their reality. There is no penalty, however, for misrepresenting their commitment to ESG. That means there is a need for further accountability in order to ensure accurate ESG reporting.
Indeed, as June Carbone from the University of Minnesota and Nancy Levit, from the University of Missouri-Kansas City – and co-authors (with me) of the forthcoming Fair Shake: Women and the Fight to Build a Just Economy – noted the metrics used in ESG reporting need further unpacking. Carbone and Levit observe that the percentage of women, for example, is meaningless in many companies without a breakdown that distinguishes the top executive ranks from entry level workers. They pointed to the most recent McKinsey report, which found that that women start out as 48% of entry-level position, but are only 28% of C-suite positions, with the percentage of women of color dropping by two-thirds.
So, on the one hand, a firm’s ESG public representations shows increased attention to the the issues and is important recognition that sustainability matters. On the other hand, “while disclosure is clearly necessary and desirable, it is never a panacea,” points out Claire Hill, a corporate law professor at the University of Minnesota. Hill emphasizes that “companies will want to depict what they do in a way that makes them look good, but doesn’t commit them to specific courses of action or statements of fact on the basis of which they could be sued.”
Consequently, a meaningful analysis of a firm’s ESG commitment requires much further digging, and ultimately it requires meaningful oversight from outside the ESG community on what should be disclosed and the accuracy of the reports.