The Impact of ESG Risk on Stocks

This article examines the impact of environmental, social, and governance (ESG) risk on US stocks through the lens of Sustainalytics’ ESG risk-rating measure over the past decade. The author finds that stocks with low ESG risk ratings (green stocks) not only have higher realized returns but also provide better tail-risk protection than stocks with high ESG risk ratings (brown stocks), especially during the COVID-19 crisis. The tail-risk protection provided by green stocks is robust within sectors and styles. Green funds and exchange-traded funds (ETFs) that hold green stocks have attracted significantly more fund flow than their counterparts, which is associated with the outperformance for both green funds and stocks. TOPICS:ESG investing, exchange-traded funds and applications, tail risks, information providers/credit ratings Key Findings ▪ The impact of ESG risk on US stocks is examined through the lens of Sustainalytics’ ESG risk-rating measure from September 2009–November 2020. Green stocks with lower ESG risk ratings outperform brown stocks with higher ESG risk ratings significantly. More important, green stocks provide better tail-risk protection than brown stocks. ▪ The energy sector accounts for the main part of the underperformance for brown stocks. When excluding stocks in the energy sector, the outperformance of green stocks shrinks. However, green stocks still provide meaningful tail-risk protection. ▪ Finally, recent evidence shows that green funds and ETFs that hold green stocks have attracted significantly more fund flows than their counterparts, which is associated with the outperformance of both green funds (including ETFs) and green stocks, as fund flow can drive persistent fund performance and stock price momentum.