Sustainable Investing in Equilibrium

Lubos Pastor is Charles P. McQuaid Professor of Finance and Robert King Steel Faculty Fellow at the University of Chicago Booth School of Business; Robert F. Stambaugh is Miller Anderson & Sherrerd Professor of Finance and Professor of Economics at The Wharton School of the University of Pennsylvania; and Lucian A. Taylor is Associate Professor of Finance at The Wharton School of the University of Pennsylvania. This post is based on their recent paper, forthcoming in the Journal of Financial Economics. Related research from the Program on Corporate Governance includes Reconciling Fiduciary Duty and Social Conscience: The Law and Economics of ESG Investing by a Trustee by Max M. Schanzenbach and Robert H. Sitkoff (discussed on the Forum here); and The Illusory Promise of Stakeholder Governance by Lucian A. Bebchuk and Roberto Tallarita (discussed on the Forum here).

Sustainable investing considers not only financial objectives but also environmental, social, and governance (ESG) criteria. Assets managed with an eye on sustainability have grown to tens of trillions of dollars and seem poised to grow further. Given this rapid growth, the effects of sustainable investing on asset prices and corporate behavior are important to understand.

We analyze both financial and real effects of sustainable investing through the lens of an equilibrium model. The model features many heterogeneous firms and agents, yet it is highly tractable, yielding simple and intuitive expressions for the quantities of interest. The model illuminates the key channels through which agents’ preferences for sustainability can move asset prices, tilt portfolio holdings, determine the size of the ESG investment industry, and cause real impact on society.

In the model, firms differ in the sustainability of their activities. “Green” firms generate positive externalities for society, “brown” firms impose negative externalities, and there are different shades of green and brown. Agents differ in their preferences for sustainability, or “ESG preferences,” which have multiple dimensions. First, agents derive utility from holdings of green firms and disutility from holdings of brown firms. Second, agents care about firms’ aggregate social impact. In a model extension, agents additionally care about climate risk. Naturally, agents also care about financial wealth.

We show that agents’ tastes for green holdings affect asset prices. Agents are willing to pay more for greener firms, thereby increasing the firms’ market prices and decreasing their costs of capital. Green assets have negative CAPM alphas, whereas brown assets have positive alphas. Consequently, agents with stronger ESG preferences, whose portfolios tilt more toward green assets and away from brown assets, earn lower expected returns. Yet such agents are not unhappy because they derive utility from their holdings.

The model implies three-fund separation, whereby each agent holds the market portfolio, the risk-free asset, and an “ESG portfolio” whose composition depends on assets’ greenness. Agents with stronger than average tastes for green holdings deviate from the market largely by overweighting green assets and underweighting brown ones. Agents with weaker ESG tastes deviate in the opposite direction, and agents with average tastes hold the market portfolio. If there is no dispersion in ESG tastes, all agents simply hold the market. Even if all agents derive a large amount of utility from green holdings, they nevertheless hold only the market if their ESG tastes are equally strong, because asset prices then fully adjust to reflect those tastes. For the ESG industry to exist, dispersion in ESG tastes is necessary. The ESG industry is largest when the dispersion in ESG tastes is greatest.

Despite earning a negative alpha, ESG investors enjoy an “investor surplus”: they sacrifice less return than they are willing to in order to hold their desired portfolio. The reason is that equilibrium asset prices adjust to ESG tastes, thereby pushing the market portfolio toward the portfolio desired by ESG investors. Specifically, ESG tastes make green firms more valuable and brown firms less valuable.  The market portfolio thus moves closer to ESG investors’ desired portfolio, pushing those investors’ negative alphas closer to zero.

We define the “ESG factor” as a scaled return on the ESG portfolio. We show that the ESG factor and the market portfolio together price assets in a two-factor model.  Assets’ loadings on the ESG factor, their “ESG betas,” equal their ESG characteristics: green assets have positive ESG betas and brown assets have negative betas. A simple version of the ESG factor is a green-minus-brown portfolio return, where both green and brown portfolios are weighted by ESG characteristics. Assets’ CAPM alphas reflect exposure to the omitted, priced ESG factor. The factor has a negative premium that comes from investors’ ESG tastes.

We interpret the ESG factor as capturing unexpected changes in ESG concerns. These concerns can change in two ways: customers can shift their demand for goods of green providers, and investors can change their appreciation for green holdings.  The ESG factor affects the relative performance of green and brown assets; its positive realizations boost green assets while hurting brown ones. If ESG concerns strengthen unexpectedly and sufficiently, green assets outperform brown ones despite having lower expected returns. This prediction helps reconcile the mixed empirical evidence on green and brown assets’ relative performance.

Our model implies that sustainable investing leads to positive social impact.  We define a firm’s social impact as the product of the firm’s greenness and its scale.  We show that agents’ tastes for green holdings increase firms’ social impact through two channels. First, firms choose to become greener, because greener firms have higher market values. Second, real investment shifts from brown to green firms, due to shifts in firms’ cost of capital (up for brown firms, down for green firms). We obtain positive aggregate social impact even if agents have no direct preference for it, shareholders do not engage with management, and managers simply maximize market value.

Finally, we extend the model by allowing climate to enter investors’ utility.  Expected returns then depend not only on market betas and investors’ tastes but also on climate betas, which measure firms’ exposures to climate shocks.  Evidence suggests that brown assets have higher climate betas than green assets. This difference pushes brown assets’ prices down and expected returns up in our model.  The idea is that investors dislike unexpected deteriorations in the climate. If the climate worsens unexpectedly, brown assets lose value relative to green assets (e.g., due to new government regulation that penalizes brown firms). Because brown firms lose value in states of the world investors dislike, they are riskier, so they must offer higher expected returns. Brown stocks thus have positive CAPM alphas not only because of investors’ distaste for brown holdings, but also because of brown stocks’ larger exposures to climate risk.

The complete paper is available for download here.

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