ESG and Expected Returns on Equities: The Case of Environmental Ratings

Using long-standing models for expected returns of US equities, we show that firm environmental ratings interact with those forecasted returns and produce excess returns both unconditionally and conditionally. Well-known factor models subsume neither environmental-related return differentials nor expected return premia from those scores and models. In addition, combining information from both inputs—expected return models and economic, social, and governance (ESG) information—may provide an advantage in selecting investments. For financial fiduciaries, this notion shifts the conversation about ESG reflecting only constraints to one of an expanded information and possibly investment opportunity set.