Sustainability Risk as an Asset Pricing Factor

Abstract

This thesis examines whether widely used asset pricing models can be improved by adding a sustainability risk factor. It constructs and assesses long-short sustainability factors in the style of Small Minus Big (SMB) and High Minus Low (HML) as in Fama & French (1993). The sustainability factors are based on the Total ESG Risk and the three individual ESG pillars’ risk for firms in the S&P500. The Total ESG Risk factor, combined with the Market, SMB, and HML factors, results in more accurate descriptions of stock returns than the CAPM and Fama-French Three Factor model. The resulting implication for finance practitioners is that omission of sustainability risk in their asset pricing models might lead to misestimations of required rates of returns.