Dynamic ESG Equilibrium

Abstract

This paper proposes a conditional asset pricing model that integrates environmental, social, and governance (ESG) demand and supply dynamics. Shocks in the demand for sustainable investing represent a novel risk source, characterized by diminishing marginal utility and positive premium. Green assets exhibit positive exposure to ESG demand shocks, hence commanding higher premia. Conversely, time-varying convenience yield leads to lower expected returns for green assets. Moreover, ESG demand shocks have positive contemporaneous effects on unexpected returns, contributing to large positive payoffs in the green-minus-brown portfolio over extended horizons. The model predictions align closely with evidence on return spreads between green and brown assets, further reinforcing the apparent gap between realized and expected spreads. This paper was accepted by Lin William Cong, finance. Funding: Y. Liu acknowledges funding by the Research Grants Council of the Hong Kong Special Administrative Region, China [Grant T35/710/20R]. A. Tarelli acknowledges funding by the European Union - Next Generation EU [Project Code 2022FWZ2CR]. The views and opinions expressed are only those of the authors. Supplemental Material: The online appendices and data files are available at https://doi.org/10.1287/mnsc.2022.03491 .