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Responsible investing: The ESG-efficient frontier

2020; Elsevier BV; Volume: 142; Issue: 2 Linguagem: Inglês

10.1016/j.jfineco.2020.11.001

1879-2774

Lasse Heje Pedersen, Shaun Fitzgibbons, Łukasz Pomorski,

Financial Reporting and Valuation Research

We propose a theory in which each stock's environmental, social, and governance (ESG) score plays two roles: (1) providing information about firm fundamentals and (2) affecting investor preferences. The solution to the investor's portfolio problem is characterized by an ESG-efficient frontier, showing the highest attainable Sharpe ratio for each ESG level. The corresponding portfolios satisfy four-fund separation. Equilibrium asset prices are determined by an ESG-adjusted capital asset pricing model, showing when ESG raises or lowers the required return. Combining several large data sets, we compute the empirical ESG-efficient frontier and show the costs and benefits of responsible investing. Finally, we test our theory's predictions using proxies for E (carbon emissions), S, G, and overall ESG.