In this note, we discuss the asset pricing implications of the increasing consideration of Environmental, Social and Governance (ESG) issues in investing.
- Environmental, Social and Governance (ESG) issues have played a
greater role in investing in recent years. In this note, we use two ESG
modelling frameworks to explore how the increased focus on ESG issues
can affect asset prices.
- We show that when investors incorporate ESG into their portfolios as a
non-financial consideration, this leads to lower expected returns on
higher ESG-scoring ‘Green’ assets, and higher expected returns on
‘Brown’ assets. As the presence of ESG-motivated investors in the
market grows, however, increased flows into Green assets can lead to
them outperforming Brown assets.
- We consider how asset prices are affected when ESG measures reflect
risks to assets’ expected cash flows. Focusing our discussion on climate
change risks, we show that the pricing of assets reflects how their
payoffs relate to the state of the economy in different climate scenarios.
Brown assets have lower cash flows in adverse climate scenarios,
implying lower prices and higher risk premiums, while Green have higher
prices and lower risk premiums. The nature of cash flow risks can
change depending on the investment horizon, for example if the
economy is able to adapt following climate shocks.
- We discuss the difficulty in empirically identifying the effects of ESG
investing on asset prices, in part due to non-financial and risk-based ESG
investing both reducing expected returns on Green assets and
increasing expected returns on Brown assets. Despite higher expected
returns on Brown assets, we might also see outperformance of Green
assets while ESG investing grows in popularity or during the transition to
widespread use of green technologies.