The Non-Performance Benefits of ESG Investing

New research confirms that investing with an environmental, social and governance (ESG) mandate does not lead to higher risk-adjusted returns. But investors will reduce exposure to climate-related risks and get the “psychic” benefit of making a positive impact for society.

Interest in ESG investing is motivated by the desire to align portfolios with investors’ values and norms; make a social impact by pushing companies to act responsibly; reduce exposure to risks, such as climate or litigation risk, faced by ESG laggards; and generate performance by favoring ESG leaders. On the last point, the research into the results of ESG investment strategies has produced conflicting results, with some papers finding that ESG investments have provided higher returns, while others found the reverse to have been the case.

In particular, older papers tended to show underperformance (there was a sin premium to owning “brown” stocks), while more recent papers reported mixed results, with some showing outperformance for ESG strategies.

The reason for the mixed results is that the research is complicated by conflicting forces – investor preferences lead to different short- and long-term impacts on asset prices and returns. Firms with high sustainable investing scores earn rising portfolio weights, leading to short-term capital gains for their stocks – realized returns rise temporarily. 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.

In other words, there is an ambiguous relationship between carbon risk and returns in the short term.