ESG and (stock) beta

Debasish Bose

Through Capital Asset Pricing Model (CAPM) equilibrium the concept of beta has been introduced in order to decompose the inherent risk of a given security to systematic (or market) and firm-specific components.
Rp (t) = p + RM (t) + ep (t)
2
+ p2 (e)
p2 = p2 M

Critical to observe that influences both return and risk. By definition beta is a pure statistical construct
regressed from historical data to measure the sensitivity of a given security to market which is evident from
this definition
=

COV (rsecurity ,rM arket )

2
M

While considering ESG factors, it seems although Environmental and Social risks are not firm-specific risks,
Governance risks partially can be factored into the firm-specific risk component (p (e)) 2
2
+ 2 wf s wgov COV (f s, gov)
gov
p2 = wf2 s f2 s + wgov

Both Environmental and Social risks are broad systematic factors like macroeconomic factor represented by
the beta () of a broad-market index like S&P500. Using multi-factor model we can introduce additional
beta to incorporate these additional ESG risk factors
Rp (t) = p + RM (t) + E E (t) + S S (t) + ep (t)
2
2 2
p2 = p2 M
+ E
E + S2 S2 + p2 (e)
Both E (t) and S (t) can be proxy indicators similar to RS&P 500 (t). Thus each security can be evaluated
with a beta vector
T otal = (, E , S )
This definitely would make the parameter estimation (regression) more complicated and introduce additional
risk elements which may not directly influence the expected return. In other words investor may have to
tolerate similar or sometimes lower (negative E or S ) expected returns while carrying increased ESG risks.
In a free capital market driven by partially rational agents, this would discourage investors from investing in

ESG-positive securities or MFs. As discussed earlier, elements of motivation have be to introduced usually
by government in form of strategic taxation policies giving short-term impetus (thus providing increased
expected returns) to investors investing in a ESG-conscious way or venturing into the territory of Impact
Investment. For example, stocks dealing with solar energy in the renewable energy sector may still forecast
lower expected returns (and often more risks through high value of |T otal |) when compared to coal-based
or fossil-fuel stocks. Pigovian taxation strategies like carbon tax are critical to counter such systemic unfairness providing a balance between short-term gain and long-term sustainable growth through ESG-friendly
investments.

0.1
Asset Pricing:
Through CAPM, beta (as depicted via Security Market Line or SML) provides a simplified framework to
evaluate asset prices for individual securities or portfolios. Any security lying above or below of the SML
is mis-priced and provides a buying or selling opportunity. However only helps in evaluating risk of a
security in relation to broad market and how its expected return behaves with changing risk. ESG risks are
however complex and long-term. Long-term impacts to environment and society are harder to quantify and
even harder to arrive at a valuation for a security using discounted cash flow model anchoring on a discount
as predicted by the CAPM-derived expected return (given a specified T ).

0.2

Estimation of Beta

is usually estimated using Ordinary Least Square regression over historical data of stock and market
(proxied via S&P500 index) returns. Thus, historical beta is very prone to stock price variations factoring
in fundamental and technical developments. They often drift over time. ESG betas (E and S ) are even
more complicated and difficult to estimate because of limited availability of quality datasets for proxies
(S (t) and E (t)). More importantly, because of its estimation from historical data, is a backward-looking
predictor variable as opposed to forward-looking indicators like forward-P/E making it a bit less valuable
while exploring ESG domains.
Alternatively many fund managers are adopting smart beta strategies and ESG ratings can be incorporated
into various smart beta factors, making it a valuable tool for portfolio construction even with ESG-positive
securities.