Sustainable Investing with ESG Rating Uncertainty

Abstract

This paper analyzes the asset pricing and portfolio implications of an important barrier to sustainable investing—uncertainty about the corporate ESG profile. In equilibrium, ESG uncertainty increases risk aversion and market premium and decreases demand for stocks. ESG uncertainty also tilts the negative ESG-CAPM alpha relation and affects individual stocks' systematic risk exposures. Employing the standard deviation of ESG ratings from six major providers as a proxy for ESG uncertainty, we provide evidence supporting the model predictions. Our findings help reconcile the mixed evidence on the cross-sectional ESG-alpha relation and suggest that ESG uncertainty could distort the risk-return trade-off.

Keywords: ESG, Rating Uncertainty, Effective Risk Aversion, Portfolio Choice, Capital Asset Pricing Model

JEL Classification: G11, G12, G24, M14, Q01