Quantifying sustainability risk from stock returns using multi-factor models – A comparison of different sustainability (risk) measures1

Abstract

This paper examines how different aspects of sustainability are incorporated into stock prices and compares their relative importance from the financial markets’ perspective, both in Europe and in the US. This study explores whether individual ESG issues have sufficient informational power for investors, and in particular compares whether environmental risk is more relevant for investors compared to social risk, and whether more clear-cut issues such as corporate emissions and employee relations are more important than resource use and community relations. To study the pricing effects, sustainability factors are constructed in the form of long-short portfolios, based on ESG scores and are added to the Carhart common factor model. Formal asset pricing tests are performed to test for the models’ explanatory power and for the risk premia associated with the factors. Overall, results show that investors in the US require higher compensation for bearing sustainability risk, suggesting higher market efficiency. In line with expectations, environmental risk is proved to be more material for investors than social risk, in Europe requiring more than 2.3 times larger risk premium. Although, compared to expectations, on average, resource use and communities related performance are incorporated into stock prices to a higher extent than emissions and workforce, results are less significant and not consistent across tests, implying that individually they might not carry enough relevant information for investors.