ESG preferences, risk and return

• Published date: 01 January 2021
• Author: Bradford Cornell
• Date: 01 January 2021
• DOI: http://doi.org/10.1111/eufm.12295

DOI: 10.1111/eufm.12295

ORIGINAL ARTICLE

ESG preferences, risk and return

Bradford Cornell

Department of Finance, Anderson School

of Management, UCLA, Los Angeles,

California, USA

Correspondence

Bradford Cornell, 607 Foxwood Rd.,

La Canada Flintridge, CA 91011, USA.

Email: bcornell@ad.ucla.edu

Abstract

There are two pri mary factors t hat affect exp ected re-

turns for companies with high ESG (environmental,

social and governance) ratings—investor preferences

and risk. Although investor preferences for highly rated

ESG companies can lower the cost of capital, the flip

side of the coin is lower expected returns for investors.

Regarding risk, the jury remains out on whether there is

an ESG‐related risk factor. However, to the extent, ESG

is a risk factor it also points towards lower expected

returns for investments in highly rated companies.

Though ESG investing may have social benefits, higher

expected returns for investors are not among them.

KEYWORDS

ESG, expected returns, investor preferences, risk

JEL CLASSIFICATION

G0; G1

1|INTRODUCTION

The massive fund flows into ESG (environmental, social and governance)‐related investments

have focused attention on the risk and return from such investments. As examples of the funds

flows, Bloomberg reported on February 8, 2019, that Europe alone has “some $12 trillion

committed to sustainable investing”. Fish et al. (2019) state that sustainable assets under

management (AUM) worldwide were approximately $30 trillion by 2019. Matos (2020) reports

that signatories to the Principles of Responsible Investment accounted for more than

$80 trillion of AUM worldwide by the end of 2019.

Finance theoryteaches that premiums over the risk‐free rate arise fromthree general sources:

(1) rewards for bearing risk, (2) behaviour biases and (3) market impediments, such as limited

liquidity. Because this paper focuses on the relation between risk, return and ESG characteristics,

it is assumed that the securities in question are traded in active developed markets so that

EUROPEAN

FINANCIAL MANAGEMENT

Eur Financ Manag. 2021;27:12–19.wileyonlinelibrary.com/journal/eufm12

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© 2020 John Wiley & Sons Ltd.

We would like to thank the anonymous referee and Editor John Doukas for their valuable comments and suggestions,

which have substantially improved the quality of this paper.