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.

Risk and Performance of European Green and Conventional Funds

“…Comparing with extant research, we show that more recent data present green funds outperforming conventional peers, similar to Ibikunle [17]. These results are also in line with Pástor et al [25], given an external shock related to more regulation and screening of firms' sustainability, green assets will exhibit higher returns, due to stronger loadings on the omitted ESG priced factor, which will reflect positive and larger CAPM alphas.…”

“…Moreover, large, well-known firms have likewise transformed their business toward sustainability, with many others opening branches focused on the renewable energy industry, and they can now pass through green funds' strict screenings. This setting, in turn, reconciles our results with Pástor et al [25]'s model: if ESG concerns exhibit a positive shock of sufficient strength, green assets outperform brown assets, despite having lower expected returns. Equilibrium asset prices adjust to ESG tastes and concerns by tilting market portfolio towards ESG investors taste.…”

“…Our purpose is to study the past returns for green funds over the European Union, in order to shed light on a vital dilemma for investors, as stated by Hamilton et al [7], if it is possible to do well while doing good or if it is required to pay a premium if investors are willing to contribute to a sustainable future to society. Under Pástor et al [25], we expect that recent regulation and appetite for green assets will provide green investors with abnormal returns given their exposure to (omitted) priced ESG factor. Following this assumption, our first hypothesis will be: Hypothesis 1 (H1).…”

“…Pástor et al [25] developed an equilibrium model which shows that investors' taste for green assets affect market prices. They argue that ESG investors will accept to pay more for green assets, which will imply a lower cost of capital and, thus, negative CAPM alphas.…”

Does excluding sin stocks cost performance?

“…Theoretically it can be shown that if certain stocks are shunned by a large group of investors, this should lead to higher expected returns for such stocks; see Pástor, Stambaugh, and Taylor (2020), Pedersen, Fitzgibbons, and Pomorski (2020), and Zerbib (2020), amongst others. Thus, the very act of excluding sin stocks can give rise to a sin premium, which can be interpreted as a reward for the reputational risk that is involved with holding sin stocks.…”