ESG as Risk Factor

Abstract

There are numerous risk factors in asset pricing models that have been identified over the years. In this paper, we address the question of whether factors constructed using ESG (Environmental, Social, Governance) scores could potentially meet the necessary requirements for risk factors in multi-factor models. While numerous studies indicate that the ESG performance of firms could be financially material, the integration of ESG factors has so far not been fully evaluated. We pay particular attention to the problem of divergent scores across different rating providers and investigate whether the regression results of 4- and 5-factor models converge. The evaluation is carried out with Fama-French and Carhart models, extended by an additional factor representing ESG, respectively. We find that there are ESG factors across all investigated rating providers that capture common-variation in stock returns over time, indicating that ESG should be considered in common asset pricing models.

Keywords: ESG, portfolio management, risk factors, ESG integration