Diversity washing – U.S. publicly traded companies overstate their commitment to DEI.
At the Gupta Governance Institute 16th Annual Corporate Governance Conference held on April 14 2023, Edward Watts, Assistant Professor of Accounting at Yale University, showed that U.S. companies overstate their commitment to diversity, equity, and inclusion, causing inflated ESG ratings and increased ownership by ESG-focused investors.
Key insights
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U.S. publicly traded corporations exhibit significant discrepancies between their disclosed commitment to diversity, equity and inclusion (DEI) and their actual hiring practices. Diversity washers (that is firms with DEI disclosures higher than their actual diversity) have less workplace diversity, experience future outflows of diverse employees, and incur more violations and penalties from the Equal Employment Opportunity Commission.
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Despite the negative DEI outcomes, diversity washers receive higher ESG scores from commercial rating organizations, suggesting their disclosures are difficult to verify and, therefore, are likely to mislead outside stakeholders and investors. Diversity washers tend to be larger firms with lower growth and lower returns.
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Relative to non-diversity washers, firms that diversity-wash have approximately 9.4% more stakes owned by socially conscious investors. Therefore, sustainable asset flows may be distorted by firms’ manipulation of their perceived ESG profile. This potential manipulation is an economic benefit to diversity-washing companies, but it constitutes an economic and social loss for investors with an ESG focus.
Summary of Complete Findings
Investors and stakeholders rely on commercial rating organizations and voluntary firm disclosures to make decisions on how to advance their environmental, social, and governance (ESG) goals. This study supports a growing number of allegations claiming that firms provide questionable portrayals of their ESG activities, most likely with the purpose of shifting the focus away from their weak financial performance. Specifically, the researchers assess the adequacy of firms’ external commitments to diversity, equity, and inclusion (DEI) in their financial filings by comparing their disclosures with a measure of their underlying employee diversity. They find a significant disconnect between the two and refer to instances where firms overstate their DEI commitments as “diversity washing.”
The study starts by exploring the relationship between a firm’s discussion of DEI activities and the actual level of diversity in the firm. It finds a positive relationship between the number of DEI words in the firms’ financial disclosures and the percentage of both non-white employees and female employees. However, this relationship is economically small, and substantial unexplained variations exist among firms.
Secondly, the researchers measure the extent to which firms have a disconnect between their DEI commitment discussions and their actual diversity. They show that 3.1% of firms in their sample are simultaneously categorized as firms with the lowest levels of diversity and the highest levels of DEI commitment discussion. Similarly, firms in the highest-disclosure quintile have approximately 13 to 15 times more DEI words in their financial reports than firms in the lowest-disclosure quintile. Overall, they conclude that DEI-based disclosure strategies of firms are largely disjoint from their underlying diversity.
The key measure of diversity washing used in the study is a binary variable that equals 1 if a firm’s disclosure percentile is higher than its diversity percentile, and it is 0 otherwise. When the measure equals one, the firm is defined as a diversity washer.
Diversity washers tend to be larger firms with higher book-to-market value and lower growth. After controlling for size and other firm characteristics, diversity washers also tend to be less profitable and have lower returns. These findings suggest that large, well-established firms experiencing poor performance may use diversity washing opportunistically to shift the focus away from their worsening financial condition.
Diversity washers are also correlated with negative DEI outcomes across multiple dimensions. They are more likely to incur penalties from the Equal Employment Opportunity Commission (EEOC) and their fines for EEOC violations are larger than those incurred by non-diversity washers.
When looking at data on policy targets set by firms for four ESG categories (diversity, energy, water, and emissions), the study finds that diversity washers are 1.27 times more likely to have an ESG policy without a target. If ESG pledges do not also involve public targets to evaluate whether firms are effectively achieving their goals, these policies may amount to little more than posturing, with minimal substance concerning how or whether a firm will achieve its goals.
In order to test whether diversity washers’ discussions are aspirational and meant to describe their ongoing efforts to improve diversity, the researchers explore the relationship between diversity washing and subsequent changes in workforce diversity. In the year immediately following the firm’s DEI disclosure, they observe a significant decline in diversity, suggesting an inverse association between the level of DEI commitment and the subsequent changes in employee diversity. In year 2 and 3 after the stated commitment, there is no sign of this negative trend reversing. The findings are further confirmed by analyzing the DEI outcome for senior-level employees separately. Therefore, it appears that diversity washers have elevated discussions on diversity commitments without enacting meaningful changes in their workforce demographics.
The study further explores two alternative channels that firms commonly use to communicate their ESG-related efforts: Corporate and Social Responsibility (CSR) reports and Twitter. Diversity washers are more likely to issue CSR reports and to have a Twitter account than their non-diversity washer counterparts. They also discuss DEI more in CSR reports and tweets. Specifically, diversity washers have 23% more DEI words in their CSR reports, and 17% more DEI words in tweets. Misleading information about ESG efforts is thus not limited to the contents of financial reports or SEC compliance reporting.
Questionable DEI disclosure tactics may be especially appealing for mature, low-performing firms because they can attract socially responsible investment (SRI) funds, which tend to be less sensitive to firm performance. Commercial ESG-rating providers are an important information intermediary in public markets and they inform investment decisions of SRI funds. Alarmingly, the researchers show that diversity washers exhibit between 2% and 13% higher ESG ratings relative to non-diversity washers, depending on the commercial ESG rating provider. The overrating likely reflects a combination of firms excessively advertising their DEI commitments in disclosures, and the inability of shareholders and stakeholders to verify actual company diversity due to the lack of reliable public data.
As a result of the limitations of available DEI information, ESG-focused investors may be misled into making poor asset-allocation decisions. In fact, relative to non-diversity washers, firms that diversity wash have approximately 9.4% more SRI fund ownership. Furthermore, SRI mutual fund ownership increases in the level of diversity washing. This implies that, despite exhibiting significantly lower outcomes for DEI-related issues, a larger than desirable share of diversity washers is held by socially conscious investors and sustainable asset flows are distorted by firms’ manipulation of their perceived ESG profile.
In conclusion, without a mechanism to hold firms accountable for reporting their ESG activities truthfully, investors and regulators should interpret disclosures cautiously to avoid economically and socially costly decisions. A failure to adequately address deficiencies in DEI data can also have negative effects on firms through costly ESG audits initiated by activist shareholders, increased scrutiny from regulators, and bad publicity that dampens customer loyalty.
“Diversity Washing” by Andrew C. Baker (University of California, Berkeley), David F. Larcker (Stanford University), Charles G. McClure (University of Chicago), Durgesh Saraph (Jump Trading), and Edward M. Watts (Yale University).
