Responsible Investing: The ESG-Efficient Frontier

Abstract

We propose a theory in which each stock’s environmental, social, and governance (ESG) score plays two roles: 1) providing information about firm fundamentals and 2) affecting investor preferences. The solution to the investor’s portfolio problem is characterized by an ESG-efficient frontier, showing the highest attainable Sharpe ratio for each ESG level. The corresponding portfolios satisfy four-fund separation. Equilibrium asset prices are determined by an ESG-adjusted capital asset pricing model, showing when ESG increases or lowers the required return. Combining several large data sets, we compute the empirical ESG-efficient frontier and show the costs and benefits of responsible investing. Finally, we test our theory’s predictions using commercial ESG measures, governance, sin stocks, and carbon emissions.

Keywords: portfolio choice, ESG, socially responsible investing, impact investing, sustainable investing, CSR

JEL Classification: D62, G11, G12, G14, G23, G34, G4, M14, Q01, Q5