Responsible Investing: The ESG-Efficient Frontier
49 Pages Posted: 18 Oct 2019 Last revised: 31 Aug 2020
Date Written: October 1, 2019
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
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