While most investors are increasingly concerned with integrating environmental, social and governance (ESG) criteria when constructing their portfolios, it is important to recognise that there are competing motivations for doing so. On the one hand, integration of ESG criteria reduces non-financial risks, such as reputation, political and regulatory risks. Companies which do not consider ESG criteria expose themselves to risks of consumer boycotts, environmental disasters or reputation scandals. Other motives include aligning portfolios with investors’ values and norms, making a social impact by pushing companies to act responsibly, reducing exposure to risks faced by ESG laggards, such as climate or litigation risk, and generating outperformance by favouring ESG leaders.
In a survey conducted in 2021 by EDHEC among European investment professionals (see Le Sourd and Martellini ), where respondents could give more than one answer, the two main reasons indicated by respondents for incorporating ESG into their investment decisions were to facilitate a positive impact on society (64%) and to reduce long-term risk (61%). About a third (34%) thought that incorporating ESG would serve to enhance portfolio performance. At the same time, more than a third of respondents (35%) said they were willing to accept a lower performance in exchange for a better ESG score.
ESG investing is indeed often presented as a source of outperformance, and ESG fund providers are fond of endorsing this perception. In this context, it is particularly important to provide a qualified assessment of such beliefs and claims, given that they are central to the understanding of the tradeoffs involved in ESG investing. After all, if ESG investing reduces risk and generates outperformance in addition to enhancing social welfare, then motives for doing good and motives for doing well would be perfectly aligned.
In this article, we analyse whether there is formal empirical support for ESG investment motivations, including most importantly risk and performance motivations. We first analyse the question from a theoretical perspective, and then discuss the empirical findings.
ESG-constrained strategies should display a lower risk-adjusted performance because a more constrained optimum is ex-ante dominated by a less constrained optimum From a theoretical point of view, achieving portfolio optimisation using a constrained universe should lead to a lower risk-adjusted performance than when using a non-constrained universe. Thus, imposing a certain level of ESG constraints on investment decisions creates an opportunity cost with a possible increase in risk and reduction in performance, compared to a portfolio optimally derived without ESG considerations.
To quantify this trade-off, Pedersen et al (2021) propose to compute an ESGefficient frontier that serves to identify both potential costs and benefits from integrating ESG considerations in portfolio selection. It involves solving a classic efficient frontier problem as defined by Markowitz, but with an additional constraint on an ESG score level. Solving the optimisation problem consists in finding the portfolio with the highest Sharpe ratio (SR) for a chosen ESG score. If one considers both the efficient frontier with no constraints on the portfolio ESG score and the one including only the assets with an ESG score over a defined level, the latter efficient frontier will necessarily stand below the former, as it is obtained by excluding some assets, and is therefore sub-optimal. This creates an opportunity cost, as the discarded assets may be profitable ones. For each ESG score, Pedersen et al (2021) show that it is possible to compute the portfolio with the highest attainable Sharpe ratio and thus define the ESG-SR frontier. If investors do not take ESG into account, they will choose the portfolio with the highest Sharpe ratio, whatever its ESG score. In the same way, Chang and Witte (2010) observe that ESG investing produces lower average returns and lower Sharpe ratios than unscreened investing.
Martellini and Vallée (2021) obtain a similar result in the context of sovereign bond portfolio construction and regarding country ESG scores. In particular, they find that higher environmental scores for developed countries and higher social scores for emerging countries are associated with lower costs of borrowing for issuers and consequently with lower yields for investors.
According to asset pricing theory, if we consider that ESG scores can be viewed as proxies for assets’ underlying risk factors, a positive risk premium should be expected for holding stocks with poor ESG scores, compared to stocks with good ESG scores (see Martellini and Vallée  for a similar argument at the sovereign bond level). However, we should also consider that excluding assets with bad performance can have a positive impact (Coqueret ). In what follows, we provide an overview of the academic insights regarding ESG investing in market equilibrium models.
It is often argued that ESG investing generates both lower risk and higher performance, which seems at odds with the key prescription from finance theory. According to asset pricing theory, systematic risk is remunerated and assets that tend to have a low payoff in ‘bad’ states of the world where marginal utility of consumption is high should have a higher expected return in equilibrium. In this context, riskier stocks with poor ESG scores should earn a higher return, and ESG filters aimed at improving the ESG score of the portfolio should therefore lead to a loss in performance.
To analyse these questions, several authors have shown how ESG can be formally integrated into market equilibrium models. In a recent paper, Pastor et al (2021) derive an equilibrium model taking into account ESG considerations. The model is based on a three-fund separation model including the risk-free asset, the market portfolio and an ESG portfolio. In this model, investors with no specific considerations for ESG will simply hold the market portfolio, while investors with special appetite for green stocks will largely deviate from the market portfolio and overweight green stocks and underweight brown stocks. Alternatively, investors with weaker interest for ESG will deviate from the market portfolio in the opposite way. The authors confirm that the preference of investors for firms with higher ESG scores lower the firms’ costs of capital, as investors want to pay more for these firms. Assets with higher ESG scores have negative CAPM alphas, whereas assets with lower ESG scores have positive alphas. Consequently, agents with stronger ESG preferences earn lower expected returns.
In a related effort, Avramov et al (2021) derive a CAPM model taking into account the level of ESG uncertainty both in alpha and beta. In this model the market beta is replaced by the effective beta, which differs from the market beta in the following way. The CAPM beta is based on the covariance and variance of actual returns; the effective beta consider that both the market and individual stock returns integrate a random additional component based on ESG, positive for a green asset and negative otherwise. Thus, the effective beta is computed using the covariance and variance of ESG-adjusted returns. As for alpha, if the CAPM model does not take into account ESG uncertainty, we will observe negative values as the willingness to hold green stocks will not be related to pecuniary benefits. On the contrary, if ESG uncertainty is taken into account, the equilibrium alpha will increase with ESG uncertainty. This model differs from that of Pastor et al (2021) in the following way. Pastor et al (2021) take into account the possibility that ESG investors will disagree about a firm’s ESG profile. However, they consider that the ESG score is certain for each investor and that investors can observe other investors’ perceived ESG values. On the other hand, Avramov et al (2021) study the implications of uncertainty about the corporate ESG profile. In their model, the investors agree that the ESG scores are uncertain and they also agree on the underlying distribution of the uncertain scores. Taking into account ESG uncertainty modifies equity premium, as well as the alpha and beta components of stock return.
Depending on the models used, different conclusions can be reached in terms of the value added by ESG constraints, and we refer the reader to Coqueret (2021) for a comprehensive review of papers considering the asset pricing model in the context of ESG investing.
After discussing the individual investment decisions and market equilibrium implications of ESG investing from a theoretical standpoint, we now turn to an analysis of the results provided by empirical studies on the subject.
The performance of ESG investment appears to be a controversial topic between those who predict a performance reduction compared to non-ESG, and those who anticipate the opposite result. The first group argues that using ESG screens will necessarily reduce the investment universe and thus lead to poor diversification (Rudd ; Barnett and Salomon ; Renneboog, ter Horst and Zhang ), as per the theoretical argument presented before. Reducing the investment universe appears to be similar to an investment constraint that leads to efficiency losses (Adler and Kritzman ). In addition, restricting portfolios to companies that fulfil ESG criteria tends to create more exposure to specific risk (eg, industry biases, style biases; see Rudd ; Kurtz ; DiBartolomeo and Kurtz ). On the contrary, ESG proponents argue that extra-financial aspects of investments are part of the investment decisions even though they may be hard to define, hard to quantify and often specific to each particular investment (Teoh and Shiu ; Bassen and Kovacs ).
In terms of risks, several empirical studies have established that stocks with a high ESG rating have a lower total risk than stocks with the same systematic risk but a lower ESG rating (Boutin-Dufresne and Savaria ; Bauer, Derwall and Hann ; Lee and Faff ). Hoepner (2010) argues that using ESG screens reduces portfolio risk, due to the lower total risk and lower specific risk of stocks with a high ESG rating. Over the 2007–12 period, De and Clayman (2015) evidenced a strong negative relationship between stock ESG rating and stock volatility, with higher ESG ratings being correlated with lower volatility. This relationship was even stronger during periods of especially high volatility, such as the 2008 financial crisis. Stocks with high ESG ratings tend to be in the low-volatility group, and stocks with low ESG ratings tend to be in the high-volatility group. Cornell and Damodaran (2020) also discuss the link between risk and company ESG scores. Companies with low ESG scores are exposed to reputational and disaster risks, either in human or financial terms, with long-term consequences. Karpoff, Lott and Wehrly (2005) find that firms that violate environmental standards suffer significant market value losses but that these losses are roughly equivalent to the legal penalties imposed. They find no evidence of additional losses from reputational damage.
While there is relative consensus on the risk reduction benefits of ESG investing, the large collection of empirical studies that have investigated ESG investment performance can be divided into three distinct groups: those which show an outperformance of ESG (Consolandi et al ; Renneboog et al , among others), those which show that ESG brings neither underperformance nor outperformance (Naffa and Fain ; Hartzmark and Sussman ; Managi et al , among others), and finally those which conclude that ESG leads to underperformance (Adler and Kritzman ; Berlinger and Lovas , among others). Kanuri (2020) also finds that, in the long run, conventional funds outperform ESG funds (in terms of average returns and Sharpe ratio), even though ESG funds sometimes perform better.
In more detail, Statman and Glushkov (2009) find that stocks with high ESG ratings outperformed stocks with low ESG ratings over the period from 1992 to 2007. De and Clayman (2015) also find a significantly positive correlation between stock ESG rating and risk-adjusted return over the 2007–12 period. They also observe that this correlation can be further improved by excluding stocks with the lowest ESG ratings. This result may be related to the low-volatility effect described in the literature (Haugen and Baker ; Jagannathan and Ma ; Ang et al ), showing the outperformance of low-volatility stocks. In addition, the authors also identify a positive ESG effect, independent of the low-volatility anomaly. Cornell and Damodaran (2020) find no evidence of higher ESG ratings being associated with greater risk-adjusted returns.
Alternatively, Fabozzi, Ma and Oliphant (2008), Hong and Kacperczyk (2009), and Statman and Glushkov (2009) report that stocks in industries involved in alcohol, tobacco, gambling, firearms, military or nuclear operations (the ‘sin’ stocks) outperform stocks in other industries. Pedersen, Fitzgibbons and Pomorski (2021), using their ESG-efficient frontier model, also find a sin stock premium, but smaller than the one estimated by Hong and Kacperczyk (2009). According to Statman and Glushkov (2009), if positive screening (selection of top ESG rating stocks) is associated with negative screening (exclusion of sin stocks), their effects will offset each other, such that ESG indexes will perform comparably to traditional indexes. In a similar register, namely that virtue does not always pay, Bolton and Kacperczy (2021a, 2021b) identify a risk premium related to high carbon emissions, ie, high-emitting firms outperform low-emitting firms.
Lioui and Tarelli (2021) use an ESG factor constructed from the various ESG ratings and find that ESG investing has generated positive alpha over recent decades, with an accumulated alpha above 1% per year for the E and S pillars. These results support the argument that “firms can do well by doing good” as suggested by Edmans (2011), Ostergaard et al (2016) and Gong and Grundy (2019), among others. However, Lioui and Tarelli (2021) identify a downward sloping pattern in the outperformance.
Brammer et al (2006), Lee and Faff (2009), Becchetti et al (2018), Lioui et al (2018), Lioui (2018a, 2018b), Ciciretti et al. (2019), Boermans and Galema (2020), Hübel and Scholz (2020) and Lucia et al (2020) all find that the rewarded ESG factors go long irresponsible firms and short responsible ones. Similarly, Luo and Balvers (2017) find that a portfolio that goes long sin stocks and short non-sin stock earns a monthly average return of 1.33%.
Friede, Busch and Bassen (2015) compiled 2000 empirical studies from 1970 to 2014 and found a non-negative impact of ESG on risk-adjusted performance. Coqueret (2021) also provides a review of empirical studies about ESG performance. Complementary results can be found in Bruno, Esakia and Goltz (2022); Lee, Fan and Wong (2021); Franco (2020); Yue et al (2020); Brunet (2018); Hvidkjaer (2017); Trinks and Scholtens (2017); and Kumar et al (2016), among others.
The question arises as to how to reconcile the theoretical prediction of a negative risk premium associated with ESG investing and the contrasted results from empirical studies. First of all, a lack of robustness in empirical findings can explain the contrasted results that may be observed depending on periods and countries. For example, Bauer et al (2005) find evidence of underperformance for German and US ethical funds compared both to ethical indices and conventional funds, while they observe a slight outperformance for UK ethical funds. However, none of these differences were found to be statistically significant after controlling for factors such as size, book-to-market and momentum. In addition, they observe the results from different sub-periods. It appears that German and US ethical funds show a significant underperformance in the beginning of the 1990s, while their performance was comparable to that of conventional funds during the 1998–2001 period. They also observe an age effect. Funds that were set up before 1998 significantly outperformed those launched after 1998. Finally, the older funds end up with a performance close to that of conventional funds, while funds that were launched recently still underperform conventional funds.
Using factor models to correct for factor effects, Di Bartolomeo and Kurtz (1999) conclude that the outperformance of the Anno Domini index compared to the market was due to factor and industry tilts rather than social responsiveness. Similarly, Bruno, Esakia and Goltz (2022) find that most of the outperformance of ESG strategies can be explained by their exposure to equity style factors that are mechanically constructed from balance sheet information. This result is robust across different multifactor models. Furthermore, the ESG strategies tested show large sector biases. Removing these biases also removes outperformance.
Alternatively, Derwall, Guenster, Bauer and Koedijk (2005) found that the higher returns generated by companies that are more eco-efficient cannot be explained by investment style or industry factors.
Cornell and Damodaran (2020) explain that market prices may adjust to a new equilibrium integrating ESG considerations. As the market adjusts, the discount rate for highly rated ESG companies will fall and the discount rate for low rated ESG companies will rise. Due to the changes in the discount rates, the relative prices of highly rated ESG stocks will increase and the relative prices of low ESG stocks will fall. Consequently, during the adjustment period the highly rated ESG stocks will outperform the low ESG stocks. Once the market is in equilibrium, the value of highly rated ESG stocks will be greater, but their expected returns will be lower.
For example, Bebchuk, Cohen and Wang (2013) report the disappearance of a return premium associated with highly rated corporate governance during an earlier period. Due to this process of adjustment, the link between the performance and the stock rating will be dependent on the sample period. During adjustment periods, highly rated stocks will outperform, while low-rated stocks will underperform. Alternatively, after that, when markets are in equilibrium, highly rated stocks will have lower average returns. According to an analysis based on the theory of Fama and French, it appears that preference for highly rated ESG stocks will cause lower average excess returns for these stocks. Again, this conclusion is not in accordance with current declarations concerning ESG, such as that of BlackRock CEO Larry Fink (2020), who stated, “Our investment conviction is that sustainability and climate integrated portfolios can provide better risk-adjusted returns to investors.”
ESG does not really provide a positive risk premium, but rather a negative risk premium, once the performance is explained by the various risk factors and investment sectors. However, ESG can generate positive returns in certain conditions, using ESG momentum. The argument for the outperformance of stocks with high ESG scores is that stock markets underreact to ESG information, and so stocks from firms with a positive ESG impact may be undervalued. The ESG momentum strategy thus consists in overweighting stocks that have improved their ESG rating over recent time periods (see Nagy et al ; Bos ; Kaiser and Schaller  for evidence of outperformance of ESG momentum strategies).
On a somewhat related note with a focus on the intersection between financial momentum and ESG scores, Kaiser (2020) argues that stocks with low ESG scores can be assumed to have more potential for momentum. According to Hillert et al (2014), momentum is related to strong media coverage. Thus, highmomentum stocks are less concerned with their ESG performance and can exhibit lower average ESG ratings, whereas stocks that are currently showing a downward trend in returns need to increase their ESG performance to send a positive signal to the market. However, Kaiser (2020) argues that the proportion of stocks showing both strong momentum patterns and a high ESG performance is likely to increase due to requirements to include such firms in investor portfolios.
While the promoters of ESG investing often argue that this type of investment strategy makes it possible to obtain better performance with lower risk, the situation is not so simple either from a theoretical point of view or from an empirical perspective. The quest for better performance should not be the only reason for ESG investing. We argue that ESG strategies should be valued for the unique benefits that they can provide, such as making a positive impact on the environment or society, as opposed to being promoted on the basis of disputable claims regarding their outperformance potential.
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