Sustainable Investing in Equilibrium

Abstract

We present a model of investing based on environmental, social, and governance (ESG) criteria. In equilibrium, green assets have negative CAPM alphas, whereas brown assets have positive alphas. Green assets' negative alphas stem from investors' preference for green holdings and from green stocks' ability to hedge climate risk. Green assets can nevertheless outperform brown ones during good performance of the ESG factor, which captures shifts in customers' tastes for green products and investors' tastes for green holdings. The latter tastes produce positive social impact by making firms greener and shifting real investment from brown to green firms. The ESG investment industry is at its largest, and the alphas of ESG-motivated investors are at their lowest, when there is large dispersion in investors' ESG preferences.

ESG investing: A chance to reduce systemic risk

“…Systematic screening of certain assets leads to a return premium on the screened assets in equilibrium (see e.g. Pastor et al, 2019, Pedersen et al, 2019, Heinkel et al, 2001and Merton, 1987. Intuitively, a systematic lower demand for the screened assets leads to a systematic lower price and thus to higher expected returns.…”

Mutual Fund Performance and Flows During the COVID-19 Crisis

“…3 Our fund-level evidence complements their stock-level evidence in highlighting the role of sustainability during the COVID-19 crisis. The model of Pástor, Stambaugh, and Taylor (2020) implies that "green" assets (those with high sustainability ratings) have lower expected returns than "brown" assets (those with low sustainability ratings), but green assets can nonetheless outperform brown assets in periods during which investors' tastes are shifting toward green assets or customers' tastes are shifting toward green products. Such a shift in tastes appears to have started before the COVID-19 crisis and, judging by our evidence as well as that of Albuquerque et al (2020) and Ding et al (2020), it continued through the crisis.…”

Does the CDS Market Reflect Regulatory Climate Risk Disclosures?

“…some previous studies observe a premium on stock returns for firms exposed to climate risk, we find that climate risk affects CDS spreads and that the perceived risk is so substantial that it affects creditors. What is more, while equity prices could in parallel be driven by investors' taste, due to divestments (see, e.g., Hong and Kacperczyk (2009) and Pastor et al (2020)), this alternative hypothesis is highly unlikely in the CDS market. Hence, our results highlight that climate risk is indeed interpreted as a financial risk.…”