Exploring the impact of ESG on factor models

Abstract

Given the increasing interest in Environmental, Social and Governance (ESG) topics, mainly driven by both rising regulation for corporations and investors appeal to long-term sustainability, it has become necessary and useful to test the relevance of the ESG factor, namely a strategy that involves going long on stocks with low ESG performance and shorting those with high ESG score, on asset pricing. This thesis investigates the integration of ESG factor in traditional factor models and its explanatory power, in particular in FF 3-factor and 5-factor models, recognizing their central role in contemporary markets. The review of the ESG topic starts with a discussion of the overall performance of ESG stocks, their evolution over time, compared to non-ESG stocks. The analysis of ESG factor is divided in two parts: first, it analyzes the factor given by the combined ESG score; second, the three pillars (Environmental, Social and Governance) are examined individually, as three factors. By outlining these “subfactors”, the aim is to capture the blended dynamics within each ESG dimension and explore their respective impacts on investment performance and risk. Further breakdown is made by analyzing the impact of factors at industry-level and within different exchanges. The analysis highlights how firms with low ESG scores experienced higher returns in the period considered than ESG leaders, implying the possibility of a particular risk borne by the former. Moreover, significant results are found when the ESG factor is added to asset pricing models in all its specifications and with varying degrees of relevance.

Date of Award	2 Jul 2024
Original language	English
Awarding Institution	Universidade Católica Portuguesa
Supervisor	António Cândido Baldaque Sousa Soares da Silva (Supervisor)