How Top Management and Investors Shape Environmental Performance and Reporting

Driven by investor demand reporting on environmental and social performance has become standard for large corporations and is now a component of firm strategy. However, investors, practitioners, and academics all doubt the reliability of third party ESG ratings due to perceived greenwashing. Identifying greenwashing and its causes remains a significant challenge. I address this measurement gap by comparing self-reported ESG practices to independently reported ESG outcomes, generating a novel measure of greenwashing. I next propose that greenwashing behavior depends on the preferences of inside stakeholders (e.g., top management) and outside stakeholders (e.g., investors). I model the interaction between these parties using a cheap talk game, in which the firm can misrepresent their ESG performance, but may be sanctioned for misrepresentation. The model predicts that the relative preferences of inside and outside stakeholders drive greenwashing behavior and ratings accuracy. I test this model’s predictions by analyzing earnings call transcripts and a firms’ shareholder composition. I find that investors’ time horizons shape reported, but not actual, ESG performance, while managers’ discussion of ESG issues on earnings calls correlates with both reported and actual ESG performance. As investors’ preferences for ESG performance increase relative to those of managers, I find firms increasingly greenwash.