Strong vs. Stable: The Impact of ESG Ratings Momentum and Their Volatility on the Cost of Equity Capital

58 Pages Posted: 22 Jun 2023 Last revised: 27 Nov 2023

See all articles by Massimo Guidolin

Massimo Guidolin

Bocconi University, Dept. of Finance; Bocconi University - CAREFIN - Centre for Applied Research in Finance

Monia Magnani

University of Liverpool Management School

Ian Berk

Bocconi University

Date Written: June 20, 2023

Abstract

We test the performance of two ESG score-driven quantitative signals on a large, multi-national crosssection of European stock returns. In particular, we ask whether in the cross-section, the cost of equity capital is more strongly affected by the (upward) “slope” (identified as momentum over a period of time) of their ESG scores or by their “stability” (identified as the volatility of the scores over a period of time), measured around a given slope. We find that 1-month, short-term ESG momentum is priced in the cross-section of stock returns and that it lowers the ex-ante cost of capital (at the same time causing realised ex-post average abnormal returns). Short-term ESG momentum may represent a novel, priced systematic risk factor. There is equally strong evidence that a ESG spread strategy that buys (sells) low (high) ESG score volatility stocks leads to a significant alpha and alters the ex-ante cost of capital. Both quantitative ESG signals lead to portfolio sorts and long-short strategies that increase the speed of improvement of the aggregate sustainability profile of the resulting portfolios with no costs in terms of average ESG scores or their stability.

Keywords: ESG ratings, ESG momentum, ESG score volatility, cross-sectional pricing, systematic risk factor.

JEL Classification: G11, G12, C59, G24

Suggested Citation

Guidolin, Massimo and Magnani, Monia and Berk, Ian, Strong vs. Stable: The Impact of ESG Ratings Momentum and Their Volatility on the Cost of Equity Capital (June 20, 2023). BAFFI CAREFIN Centre Research Paper No. 202, Available at SSRN: https://ssrn.com/abstract=4485470 or http://dx.doi.org/10.2139/ssrn.4485470

Massimo Guidolin (Contact Author)

Bocconi University, Dept. of Finance ( email )

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Bocconi University - CAREFIN - Centre for Applied Research in Finance

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Milan, 20136
Italy

Monia Magnani

University of Liverpool Management School ( email )

Ian Berk

Bocconi University ( email )

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