Pricing ESG in Factor Investing: The complications of using ESG in Factor Investing

Klaus Ejlsted & Mikkel Søvndahl Poulsen

Student thesis: Master thesis

Abstract

This thesis seeks to investigate whether there is a risk premium for ESG by looking at the relationship between ESG ratings and the US stock market in the period from 2002-2019. Earlier studies disagree on whether ESG-factors are priced, and this thesis seeks to contribute to this discussion. A two-pass cross-sectional regression analysis is used to determine the risk premia for factors. The regression analysis shows that when using the ESG ratings from Refinitiv, the ESG-, and G-factors are not priced, but the S-factor is shown to be priced with a negative risk premium. As there are few examples of papers trying to explain the reason for the factors being significant or not, a behavioural finance perspective is applied to seek possible explanations of the results. This thesis finds indications of bounded rationality affecting investors’ decisions. The study also shows problems with the methodologies used by rating providers and raises concerns about ESG ratings being used out of the scope, as predicting returns is not what they are intended for. Furthermore, the thesis suggests alternative uses for ESG ratings that are not fixed on financial performance. The paper concludes with a section on considerations that investors should make before implementing ESG in an investment strategy.

EducationsMSc in Finance and Accounting, (Graduate Programme) Final ThesisMSc in Accounting, Strategy and Control, (Graduate Programme) Final Thesis
LanguageEnglish
Publication date2022
Number of pages108
SupervisorsKristjan Jespersen