{"id":107533,"date":"2021-10-18T11:20:20","date_gmt":"2021-10-18T15:20:20","guid":{"rendered":"https:\/\/ibkrcampus.com\/?p=107533"},"modified":"2022-11-21T09:48:31","modified_gmt":"2022-11-21T14:48:31","slug":"the-impact-of-esg-scores-on-asset-prices","status":"publish","type":"post","link":"https:\/\/www.interactivebrokers.com\/campus\/ibkr-quant-news\/the-impact-of-esg-scores-on-asset-prices\/","title":{"rendered":"The Impact of ESG Scores on Asset Prices"},"content":{"rendered":"\n

The post “The Impact of ESG Scores on Asset Prices” first appeared on Alpha Architect Blog<\/a>.<\/em><\/p>\n\n\n\n

Sustainable investing has grown substantially in recent years, demonstrating that investor demand can be driven by nonfinancial issues such as environmental (E), social (S), and governance (G) characteristics. A full list of our posts on ESG can be found here<\/a>. The demand from investors who have a preference for investing based on their values could impact valuations and thus expected returns. Economic theory suggests that if a large enough proportion of investors choose to favor companies with high sustainability ratings (choosing conscience over returns) and avoid those with low sustainability ratings (\u201csin\u201d businesses), the favored company\u2019s share prices will be elevated, and the sin stock shares will be depressed. Specifically, in equilibrium, the screening out of certain assets based on investors\u2019 taste should lead to a return premium on the screened assets.<\/p>\n\n\n\n

The result is that the favored companies will have a lower cost of capital because they will trade at a higher price-to-earnings (P\/E) ratio. The flip side of a lower cost of capital is a lower expected return to the providers of that capital (shareholders). And the sin companies will have a higher cost of capital because they will trade at a lower P\/E ratio. The flip side of a company\u2019s higher cost of capital is a higher expected return to the providers of that capital. The hypothesis is that the higher expected returns (a premium above the market\u2019s required return) are required as compensation for the emotional cost of exposure to offensive companies. On the other hand, investors in companies with higher sustainability ratings are willing to accept the lower returns as the \u201ccost\u201d of expressing their values.<\/p>\n\n\n\n

There is also a risk-based hypothesis for the sin premium. It is logical to hypothesize that companies neglecting to manage their ESG exposures could be subject to greater risk (that is, a wider range of potential outcomes) than their more ESG-focused counterparts. The hypothesis is that companies with high sustainability scores have better risk management and better compliance standards. These stronger controls lead to fewer extreme events such as environmental disasters, fraud, corruption, and litigation (and their negative consequences). The result is a reduction in tail risk in high-scoring firms relative to the lowest-scoring firms. The greater tail risk creates the sin premium.<\/p>\n\n\n\n

Conflicting Forces<\/strong><\/h2>\n\n\n\n

Investor preferences can lead to different short- and long-term impacts on asset prices and returns. Firms with high sustainability scores earn rising portfolio weights, leading to short-term capital gains for their stocks\u2014realized returns rise temporarily due to a positive shock to the discount rate applied to their future earnings. However, the long-term effect is that higher valuations reduce expected long-term returns. The result can be an increase in green asset returns even though brown assets earn higher expected returns\u2014there can be an ambiguous relationship between carbon risk and returns in the short term, creating what could be called the \u201cESG return puzzle.\u201d The puzzle refers to the phenomenon that, recently, realized stock returns have tended to be positively related to ESG, while expected returns tend to be negatively related to ESG (though over time we should expect a positive relationship between returns and ESG risk). Without this understanding, investors can misinterpret findings that appear to show a lack of a sustainability risk premium.<\/p>\n\n\n\n

The Evidence<\/strong><\/h2>\n\n\n\n

Olaf Stotz contributes to the sustainable investing literature with his study \u201cExpected and Realized Returns on Stocks with High\u2011 and Low\u2011ESG Exposure,\u201d published in the\u00a0March 2021 issue of the Journal of Asset Management<\/a>. Stotz analyzed the two channels that impact realized and expected returns: the cash flow channel (do high-scoring ESG firms benefit from\u00a0unexpected<\/em>\u00a0improvements in profitability?) and the discount rate channel (do high-scoring ESG stocks benefit from a falling discount rate?). He used a valuation model (from the study \u201cToward an Implied Cost of Capital<\/a>\u201d) and analysts\u2019 earnings estimates to compute a firm\u2019s implied cost of capital, which is an estimate of the expected return. Using a large sample of U.S. companies from 2008 to 2018, he formed a hedge portfolio that was long in high-ESG stocks and short in low-ESG stocks (an HL portfolio).<\/p>\n\n\n\n

Following is a summary of his findings:<\/p>\n\n\n\n