The Price of ESG: Risk & Return in Sustainable Investing

Abstract

This thesis examines the association between ESG and financial performance, as well as the risk dimension of sustainability. The analysis is conducted using the S&P 500 as sample over a sample period from January 2008 to February 2022. The objective is to provide a viable answer to whether investing sustainably comes at a cost. At the outset, this thesis hypothesizes the existence of a non-sustainability risk premium. This hypothesis follows the logic that if sustainability serves to alleviate certain risks, investors will naturally require a risk premium for investing in non-sustainable companies. This translates to outperformance of low ESG-stocks and an expected risk premium for non-sustainability. Applying annual Refinitiv ESG scores, we construct 36 value-weighted portfolios based upon three ESG-based strategies, namely best-in-class, ESG momentum, and thematic tilt. The link between alpha and ESG is assessed using the Fama-French three- and five-factor models. In the time-series analysis, we find that investors cannot generate abnormal returns, positive or negative on neither the top, bottom nor long-short portfolios based on the considered ESG scores, except for the top Shareholders portfolio. However, this alpha ceases to exist in the five-factor framework. These results are echoed by a cross-sectional analysis, in which significant associations between excess asset returns and ESG Scores are not identified for the majority of examined scores. Significant positive association is only identified for the Governance and Emission Score. The empirical results suggest that investors, in general, are neither financially penalized nor rewarded from investing sustainably, nor does non-sustainable firms warrant a non-sustainability risk premium. Investors can thus do well in sustainability without compromising returns, and the empirical evidence therefore suggests that there is no price to be paid for investing sustainably. These conclusions do not support the hypothesis of a non-sustainability risk premium which was established at the outset of the analysis. These findings contribute to the ongoing debate in academia on the financial materiality and relevance of ESG information in asset pricing. Furthermore, implications of the results are appealing in relation to asset management and investment business practices because the empirical evidence suggests that asset managers and owners alike can satisfy their ESG preferences in a harmonious manner – by doing good in sustainability without compromising returns.