Responsible Minus Irresponsible - a determinant of equity risk premia?

ABSTRACT

This study attempts to explain the relationship between ESG and financial performance. It utilises a new method for constructing an ESG portfolio with a high exposure towards ESG that eliminates the inherent correlation between size and ESG. In that perspective, a zero initial investment portfolio that goes long in responsible companies and short in irresponsible companies is adopted; hence, developing a ‘Responsible Minus Irresponsible’ (RMI) factor mimicking portfolio. A pricing anomaly test on this portfolio suggests that ESG exerts superior financial performance, mostly as a result of a significant lower market risk. Performing a cross-sectional analysis of different factor models on an international set of company returns indicates a negative effect of ESG on expected returns. However, the ESG factor becomes insignificant once multiple factors are introduced as explanatory variables. Consequently, ESG represents a pricing anomaly but does not act as an independent risk factor.

KEYWORDS:

• Sustainable finance
• ESG
• factor analysis
• COVID-19
• SRI

Disclosure statement

No potential conflict of interest was reported by the author(s).

Data availability statement

The data are available on request.

Notes

1 https://www.refinitiv.com/content/dam/marketing/en_us/documents/methodology/esg-scores-methodology.pdf

2 https://www.msci.com/esg-indexes