Many businesspeople believe that companies cannot use their financial resources to improve social or environmental performance without decreasing shareholder value. A common line of reasoning is that a company’s costs of adhering to ethical standards will translate into higher product prices, a competitive disadvantage, and lower profitability (Walley and Whitehead 1994).
Others believe that improved social or environmental performance can enhance a company’s input–output efficiency or generate new market opportunities. Porter and Van der Linde (1995) argued that active policies to improve environmental performance can create a competitive advantage because of the more cost-efficient use of resources. If this argument is true and the benefits of social or environmental initiatives outweigh their costs, then businesses that embrace the concept of corporate environmental responsibility should be able to report higher corporate earnings than less responsible companies.
The extent to which social or environmental screening policies contribute to investment returns, however, depends on the financial markets’ ability to factor the financial consequences of corporate social responsibility into share prices. The belief is widespread that at the investment level, incorporating ethical criteria into investment decisions comes at the cost of portfolio performance. Asset-pricing theory that relies on the efficient market hypothesis posits that (1) investment portfolios deliver returns proportional to associated risk and that (2) the optimal investment portfolio is a well-diversified one. Therefore, any empirical evidence of anomalous risk-adjusted investment performance on the part of stocks grouped by company-specific characteristics—such as size, book-to-market ratio (BV/MV), or corporate social responsibility—are attributable to deficiencies in the performance evaluation models that attempt to explain them. After the methodological shortcomings are corrected, no abnormal returns should exist.