The Crowding-Out Effect of ESG Practices on Social Welfare: Evidence from China

This paper analyzes the crowding-out effect of firms’ environmental, social, and governance (ESG) activities, arguing that ESG rating convergence among firms makes investors hesitant, driving down economic and social welfare growth. This is yet another adverse consequence of overcompetition in ESG practices in addition to greenwashing. We first build a model to show that, although ESG incentive policies can improve social welfare in the short run, they may reverse long-term social welfare growth, resulting in an ESG-paradox situation. Empirically, we use various proxies of provincial social welfare and the distribution of ESG score changes for China’s A-share companies and detect a significantly reduced impact on the social welfare growth of a Chinese province by either a lower standard deviation or skewness of annual ESG score growth calculated for all firms registered within that province. Overall, our findings reveal the complexity of formulating ESG incentive policies and suggest that firms should strike a strategic balance between their business operations and social responsibility when determining their optimal ESG input level.