Dynamic ESG Equilibrium

Abstract

This paper proposes a conditional asset pricing model that integrates ESG demand and supply dynamics. Shocks in the demand for sustainable investing represent a novel risk source, characterized by diminishing marginal utility and positive premium. Green assets exhibit positive exposure to ESG demand shocks, hence commanding higher premia. Conversely, time-varying convenience yield leads to lower expected returns for green assets. Moreover, ESG demand shocks have positive contemporaneous effects on unexpected returns, contributing to large positive payoffs in the green-minus-brown portfolio over extended horizons. The model predictions align closely with evidence on return spreads between green and brown assets, further reinforcing the apparent gap between realized and expected spreads.

Keywords: ESG, Dynamic equilibrium, Asset pricing, Preference shock

JEL Classification: G12, G19, J71