Constructing and Validating Climate Risk Factors from ESG Data: an Empirical Comparison

Abstract

Increased concern about climate change has led many investors to focus on its effects on portfolio returns. ESG metrics used for analyzing climate risks, however, have been shown to be inconsistent. What would happen if they were used in analyzing the climate risks of portfolios and making climate-aligned investments? In this paper, we look at different ways to incorporate ESG metrics into the investment process by creating climate factors for use with multi-factor equity returns models. We found that different ESG metrics do indeed lead to very different, sometimes even opposite, investment recommendations. At the same time, it was possible to create at least one climate factor from Exchange Traded Funds which could be used to identify investment opportunities and monitor climate risks in the Energy industry. This suggests that the market is trading to a systematic climate factor in at least one industry. The methodologies in this paper for validating the climate factors created from ESG metrics could be used to develop climate factors for other industries. It could also be used to test the validity of ESG metrics and of the integration of climate risk analysis into managers’ investment processes.

Keywords: ESG, Climate investing, Factor models, Carbon, climate change, risk factor, carbon beta

JEL Classification: G11, Q54