ESG Investing: A Tale of Two Preferences

Abstract

What motivates ESG integration? I find both non-pecuniary and risk-mitigating preferences explain its prominence. A novel test based on changes in mutual funds’ portfolio holdings and several empirical findings establish the two widely endorsed ESG ratings proxy these preferences. With this, I show each preference induces sizable equity premium identified through option-implied expected returns. Due to unexpectedly persistent demand growth for ESG-conscious assets, realized returns mask true ESG pricing effects, especially those attributable to non-pecuniary preference. Consequently, this paper lends support to recent theoretical frameworks with non-pecuniary preference and explains why empirical literature has lacked consensus.

Keywords: Environmental, Social, Governance (ESG) investing, Non-pecuniary preference, ESG equity premia, Externalities, Option-implied moments.

JEL Classification: G11, G12, G13, G41, M14