ESG Integration Adoption Increases Expected Returns

    Stockholm (NordSIP) – The wide range of initiatives, international agreements and industry efforts in support of the ESG agenda has proven fertile ground for increasingly sophisticated research on the financial effects of these efforts. At a time of alarming inaction and during a week that’s seen Switzerland join the G7, New Zealand and Hong Kong in opening the way for mandatory climate disclosures, we take the opportunity to consider the latest insight on this topic from Norges Bank Investment Management.

    Using two ESG modelling frameworks, the NBIM article explores how the increased focus on ESG issues can affect asset prices. Its conclusions provide a nuanced picture of the effect of ESG integration.

    The research argues that the incorporation of ESG as a non-financial consideration leads to lower expected returns on higher ESG-scoring ‘Green’ assets, and higher expected returns on ‘Brown’ assets. However, as the presence of ESG-motivated investors in the market grows, however, increased flows into Green assets can lead to them outperforming Brown assets.

    The study considers how asset prices are affected when ESG measures reflect risks to assets’ expected cash flows. Focusing our discussion on climate change risks, the authors argue that the pricing of assets reflects how their payoffs relate to the state of the economy in different climate scenarios. “Brown assets have lower cash flows in adverse climate scenarios, implying lower prices and higher risk premiums, while Green have higher prices and lower risk premiums. The nature of cash flow risks can change depending on the investment horizon, for example if the economy is able to adapt following climate shocks.”

    According to the article, determining the magnitudes of equilibrium effects of non-financial and risk-based motives either in equilibrium or during the green transition is challenging. Obtaining estimates of the distribution of ESG preferences across investors as well as the size of capital they allocate to ESG investing is one of the main hurdles.

    “While there is suggestive evidence that the amount of capital allocated to ESG investing has been growing rapidly, precise estimates of both inputs are hard to obtain. Recent developments in incorporating data on portfolio holdings into asset pricing models present a promising avenue of research for understanding the role of ESG in investing. We also have less evidence available to assess the long-term impact of climate change, and the effects on broader equity market or global asset classes. As the green transition progresses, more data will become available, and it is also reasonable to expect that more resources will be devoted to empirical research on these issues,” the article concludes.

    Filipe Albuquerque
    Filipe Albuquerque
    Filipe is an economist with 8 years of experience in macroeconomic and financial analysis for the Economist Intelligence Unit, the UN World Institute for Development Economic Research, the Stockholm School of Economics and the School of Oriental and African Studies. Filipe holds a MSc in European Political Economy from the LSE and a MSc in Economics from the University of London, where he currently is a PhD candidate.

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