Issue 6 of Review of Finance, Volume 26, 2022
November 18, 2022

Dear EFA Member,

As a current or recent EFA member, we are pleased to forward you the contents of the recently published Special Issue on Sustainability of Volume 26 of the Review of Finance – the EFA’s own journal – along with digests (short summaries) and abstracts.


Sustainable finance—the integration of environmental, social, and governance (“ESG”) issues into financial decisions—is an increasingly important topic. Within companies, sustainability is no longer an ancillary issue confined to corporate social responsibility departments, but a CEO-level issue fundamental to the core business. Within the investment industry, sustainability used to be the exclusive domain of “socially responsible investors” who had social as well as financial objectives, but is now mainstream and includes investors with purely financial goals. More broadly, the sustainability of business has a crucial impact on how it is viewed by wider society, including policymakers and citizens, including its social license to operate.

The increasing interest in sustainability among investors—which, in turn, flows through to companies—stems from three forces. The first is financial relevance. Companies with a positive impact on society may be more likely to attract customers and employees, capture business opportunities related to societal trends such as climate change and financial inclusion, and avoid environmental fines or regulatory intervention. If these benefits are not fully priced in, such companies will generate high risk-adjusted returns, and thus even investors with purely financial motives will prefer them. The second is nonfinancial objectives. For example, a pension fund invests on behalf of its beneficiaries, who care not only about their income in retirement but the state of the planet and the cohesiveness of society. Thus, they may support a company increasing its societal impact even if doing so sacrifices profits.

The third is tastes—that investors prefer to hold “green” stocks over “brown” stocks. Note that the second and third channels are subtly different. Under the second channel, a sustainable investor would only sacrifice financial returns if doing so has a causal impact on societal returns—for example, divesting from a “brown” stock increases its cost of capital and hinders it from expanding. Under the third channel, no causal effects are necessary. Even if the supply of capital is perfectly elastic, so divestment has no price impact, a sustainable investor will still boycott a brown stock since she suffers disutility from holding such a company.1

Due to this increasing importance, the Review of Finance launched a Special Issue on Sustainable Finance. Among 176 submissions we received between June and December 2021, we aimed to publish papers that meet the following ordered criteria: (i) papers that are high-quality academic work; (ii) papers that are of interest to a mainstream finance audience, not only readers who work in sustainable finance; (iii) papers that have implications for both theoretical and empirical research, and for both academia and practice. We sought to publish papers across all major research areas: corporate finance, asset pricing, financial intermediation, behavioral finance, and mutual funds. This Special Issue contains eight papers that satisfied the above criteria. We would like to emphasize the important role of the reviewers, whose hard work has enabled us to put this issue together. Their input has been invaluable to the success of this endeavor.

You can read the full editorial here by guest editors Marcin Kacperczyk and Alex Edmans, in which they summarise each paper's content and placement in the broader discussion on the topic in the order in which they appear in the issue.

Below we present the digests for the current issue.


Authors: Florian Berg, Julian F Kölbel, Roberto Rigobon

ESG (environmental, social, and governance) rating agencies have become influential institutions in today’s financial markets, affecting a wide range of important decisions. Yet, ESG ratings from different providers diverge, introducing uncertainty into those decisions and creating a challenge for decision-makers.

This paper investigates why ESG ratings diverge. The analysis is based on data from six prominent ESG rating agencies:

  • Sustainalytics
  • Moody's ESG (formerly known as Vigeo-Eiris)
  • S&P Global (formerly known as RobecoSAM)
  • Refinitiv (formerly known as Asset4)
  • MSCI
  • KLD (discontinued 2017)

We document an average pairwise correlation between these ESG ratings which ranges from 38% to 71%. The divergence is illustrated in Figure 1 (shown below). It shows that while ESG ratings rarely provide diametrically opposing assessments, the dispersion makes it difficult to tell firms that are ESG leaders from average performers.

To explain the reasons for divergence, we use a dataset that consists of the aggregate ratings along with the full set of underlying indicators. We categorize all indicators into a common taxonomy of 64 attributes and re-estimate the original ratings based on this taxonomy. This allows us to compare different rating methodologies in one coherent framework.

We decompose the divergence into three components: scope, measurement, and weights. Scope divergence means that ratings are based on different sets of attributes. Measurement divergence means that rating agencies measure the same attribute using different indicators. Weights divergence means that rating agencies assign different weights to attributes when aggregating them to a single rating. We find that measurement is responsible for 56% of the overall divergence, scope for 38%, and weights for 6%.

We also detect a rater effect where a rater's overall view of a firm influences the measurement of specific categories. This suggests that measurement divergence is not just randomly distributed noise but has structural reasons as well, which calls for more research investigating why this is the case.

ESG rating divergence does not imply that measuring ESG performance is a futile exercise. However, it highlights that measuring ESG performance is challenging, that attention to the underlying data is essential, and that the use of ESG ratings and metrics must be carefully considered for each application. Investors can use our methodology to reconcile diverging ratings and focus their research on those categories where ratings disagree. For regulators, our study points to the potential benefits of harmonizing ESG disclosure and establishing a taxonomy of ESG categories. Harmonizing ESG disclosure would help to provide a foundation of reliable data. A taxonomy of ESG categories would make it easier to contrast and compare ratings within this common taxonomy.


Authors: Olivier David Zerbib

This paper shows how sustainable investing—through the joint practice of exclusionary screening and environmental, social, and governance (ESG) integration—affects asset returns. The author develops an asset pricing model with partial segmentation and heterogeneous preferences. He characterizes two exclusion premia generalizing Merton’s (1987) premium on neglected stocks and a taste premium that clarifies the relationship between ESG and financial performance. Focusing on U.S. stocks, he estimates the model by applying it to sin stocks as excluded assets and using the holdings of green funds to proxy for environmental integration. The average annual exclusion effect is 2.79% for the period 1999–2019. Although the annual taste effect ranges from −1.12% to +0.14% across industries for 2007–2019, the taste effect spread between the top and bottom terciles of companies within each industry can exceed 2% per year. The author estimates and explains the dynamics of these premia.


Authors: Rajna Gibson Brandon, Simon Glossner, Philipp Krueger, Pedro Matos, Tom Steffen

There is growing interest globally in responsible investing, whereby institutional investors incorporate environmental, social, and governance (ESG) issues into their investment processes. We study the leading initiative, the Principles for Responsible Investment (PRI), which was founded in 2006 by some of the world’s largest institutional investors and reached combined assets under management of over US$ 120 trillion at the end of 2021. Our focus is whether institutions who commit to invest responsibly by joining the PRI do so in practice, as responsible investing can only make the world more sustainable if investors live up to their commitments.

We examine whether PRI signatories in general and especially those with higher reported levels of ESG incorporation in the annual PRI reporting framework have more sustainable equity portfolio allocations. For this purpose, we combine filings by institutional investors on their equity holdings around the world with stock-level ESG ratings from three leading ESG data providers to calculate value-weighted ESG scores at the portfolio level. We call these portfolio ESG scores and use these to quantify the extent to which an institutional investor is incorporating ESG issues into their investment analysis and decision-making processes (Principle 1 of the PRI).

We find that PRI signatories have better portfolio ESG scores than non-PRI signatories – but this holds only for institutions domiciled outside of the U.S. In the U.S., we observe a substantial disconnect between what institutional investors claim to do in terms of ESG and what they really do. We do not find better portfolio ESG scores for US PRI signatories, not even for those that report full ESG incorporation. US PRI signatories that report no ESG incorporation in fact have worse scores than non-PRI investors if they have underperformed recently, are retail-client facing, and joined the PRI late. We also find no evidence that US PRI signatories improve the ESG scores of portfolio companies after investing in them. This raises concerns about greenwashing (i.e., overstating an institution’s commitment to sustainable investing) among US PRI signatories. The difference in findings between the US and non-US PRI signatories appears to be driven by a combination of factors: (1) commercial incentives to become a PRI signatory being higher in the US than elsewhere; (2) more regulatory uncertainty in the U.S. as to whether ESG investing is consistent with institutions’ fiduciary duties; and (3) less ESG market maturity in the U.S. and hence less pressure for ESG implementation.

Overall, our results highlight that—at least in the U.S.—end investors need to look beyond the PRI label alone when evaluating investment managers on their sustainability credentials and the true alignment between their responsible investing commitments and actions. One may wonder about the ability of responsible investing to drive change in corporate ESG practices in the U.S.


Authors: Steven D. Baker, Burton Hollifield, Emilio Osambela

Elementary portfolio theory implies that environmentalists optimally hold more shares of polluting firms than non-environmentalists, and that polluting firms attract more investment capital than otherwise identical non-polluting firms through a hedging channel. Pigouvian taxation can reverse the aggregate investment results, but environmentalists still overweight polluters. We introduce countervailing motives for environmentalists to underweight polluters, comparing the implications when environmentalists coordinate to internalize pollution, or have nonpecuniary disutility from holding polluter stock. With nonpecuniary disutility, introducing a green derivative may dramatically alter who invests most in polluters, but has no impact on aggregate pollution.


Authors: Nickolay Gantchev, Mariassunta Giannetti, Rachel Li

There is an ongoing debate about whether divestitures can influence firms’ environmental and social (E&S) policies. Theory provides conflicting predictions. On the one hand, if investors vote with their wallets and spurn firms that fall short of their expectations on E&S standards, such firms are expected to experience a higher cost of capital, which would in turn hamper their ability to invest. Thus, managers may have incentives to improve corporate E&S policies to enhance their firm’s reputation and decrease its cost of capital. On the other hand, market discipline is ineffective if the proportion of agents who are motivated by E&S concerns is small or the demand by other investors is very elastic.

This debate largely ignores that shareholders discipline managers through their exit decisions and could thus also affect firms’ E&S policies. If this were the case, market discipline, that is, the investment decisions of even small E&S-conscious investors, could lead to a more sustainable economy.

We study whether, and under what conditions, divestitures and the threat of exit are effective in channeling investors’ E&S preferences to firms and triggering changes in firms’ E&S policies.

We conjecture that following a negative E&S incident, the exits of a few E&S-conscious investors are likely to increase managerial concerns that even more E&S-conscious investors could revise downwards their beliefs about the firms’ E&S standards and sell if more E&S incidents were to happen. Firms may also wish to attract back the E&S-conscious investors that divested to improve their valuations. Thus, following an E&S incident, the managers of firms with ex-ante more E&S-conscious investors are expected to have stronger incentives to improve their E&S policies and avoid future E&S incidents, especially if they care about the firms’ market valuations because they receive equity compensation.

We find that E&S incidents are followed by some, but relatively small, divestitures. The average market reaction to a negative E&S incident is also close to zero. However, negative realizations of E&S risks trigger more pronounced negative abnormal returns in firms with ex-ante more E&S-conscious investors. For instance, a one-standard-deviation increase in E&S-conscious institutional ownership is associated with a 0.058% decrease in the five-day CAPM-adjusted CARs.

This suggests that market prices reflect investors’ preferences and discontent with firms’ E&S policies. Importantly, the extent of discontent following E&S incidents, proxied by a more negative market reaction, is associated with subsequent improvements in firms’ E&S policies. We estimate that firms with a one-standard-deviation higher E&S-conscious institutional ownership decrease their greenhouse gas emissions by 36.5% and improve their E&S scores by 7.2% more than other firms if their managers receive equity compensation. Importantly, in the years following the initial E&S incidents, companies that improve their E&S policies experience an increase in ownership by E&S-conscious investors and improve their corporate valuations.

We do not observe any improvements associated with sales in E&S-conscious countries. Our results suggest that the threats of future exits and divestitures can improve E&S policies if shareholders are E&S-conscious and managers’ compensation is linked to the stock price.


Authors: Duc Duy Nguyen, Steven Ongena, Shusen Qi, Vathunyoo Sila

Does the residential property market incorporate risks related to sea level rise (SLR)? Several recent studies examine prices of US coastal homes. Evidence so far is mixed and suggests that there are barriers that prevent homebuyers, who are mainly retail investors, from incorporating SLR risks into house prices.

We tackle this question by examining mortgages on residential properties. While both residential mortgages and residential properties are exposed to similar risks (e.g. the uncertainty of home values and future cash flows due to SLR), financial institutions should be more sophisticated than average investors. While an average investor may purchase a house only a few times in their life, banks process a large volume of mortgage applications every day. Further, financial institutions are likely to have sophisticated risk systems in place that can appropriately identify, measure, and incorporate climate change risk.

Our results suggest that even for sophisticated investors such as banks, their ability to price SLR risk in residential mortgages is limited. We document a modest “SLR premium” in the residential mortgage market: lenders charge higher interest rate spreads on mortgage for properties exposed to greater SLR risk. For a $506,712 mortgage (our sample average), this SLR premium translates to about $9,000 increase in financing cost. We further evaluate the increase in implied probability of default associated with the SLR premium and find that the implied increase in default probability associated with the SLR premium is small compared to benchmarks in recent studies. These results suggest that financial institutions may not yet incorporate the full extent of SLR risk into their pricing of residential mortgages.

Moreover, we find that that lenders’ attention and attitudes towards climate change risk could be the mechanisms that prevent them from incorporating SLR risk into mortgage pricing. The SLR premium is less salient in the 1990s, when climate change was less recognized. Further, we find that the SLR premium is more salient following a hurricane or periods of heightened media attention to climate change. However, these effects quickly disappear, suggesting that lenders’ attention to climate change is short-lived. The SLR premium is also smaller in areas where fewer local residents (including local loan officers) believe that climate change is happening. Experience of lenders also matter, as we find that SLR premium is larger among small/local banks, banks that engage more in traditional banking activities, and banks that handle more mortgage applications for properties exposed to SLR risk.

Our paper adds to the understanding of how SLR risk is incorporated in residential properties by showing that banks are aware and attempt to price this risk in residential mortgages. However, the modest economic magnitude of the SLR premium, together with its sensitivity to factors such as local beliefs, attention, and lenders’ experience, highlight the challenges lenders face in incorporating and managing risks related to SLR. Our findings are especially important from a regulatory perspective because it demonstrates that a more standardized approach to measure and incorporate climate-related risk may be needed.


Authors: Anders Anderson, David T Robinson

Anthropogenic climate change has made sustainable investment a hot topic across the globe. Increasingly, financial market participants place growing importance on sustainability and other ESG considerations. Ultimately, these trends raise questions about the nature of underlying household demand for socially responsible behavior from firms and other financial market participants.

To better understand the impact of ESG preferences on capital market outcomes and firm behavior, a number of recent theoretical papers have taken up the connection between pro-social shareholder preferences and corporate behavior or asset prices. A common feature across models is the assumption that investors express their pro-social preferences through their portfolio choice decisions.

In this paper we empirically test this basic premise. Focusing specifically on environmental considerations (the E in ESG), we ask a simple question: do green households make green financial decisions? To do this we ask Swedish households their views about sustainable investment (see Figure). Then we connect the responses to administrative data that allow us to relate pro-environmental attitudes and values to retirement savings behavior and direct stock holdings.

We find that pro-environment households are not more likely to hold pro-environment portfolios. There are two key factors that drive this result. The first is financial disengagement. Households that exhibit strong pro-environmental behaviors and beliefs are financially disengaged and generally uninterested in financial matters. Individuals who place a high priority on environmental considerations are around 10\% less likely than others to hold stock directly, controlling for demographics. The magnitude of this effect is large compared to other demographic variables. In a mandatory-participation national retirement plan, they are 20% less likely than others to check their retirement balance, and they are less likely to make an active allocation decision, instead relying on the default allocation option.

The second factor is the presence of informational constraints. Making green investment decisions involves added layers of informational complexity; these prevent less financially sophisticated individuals from expressing their green preferences through their portfolio holdings. For example, among those who make an active choice in their retirement portfolios, environmentally oriented investors are more likely to buy mutual funds with pro-environmental names, but they are not more likely to buy funds that are labeled as ESG-compliant in the more complex financial statements that households receive every year.

These same households say they recycle more than their neighbors, and say they are willing to pay more for green products. This environmental engagement simply does not to cross over into the realm of financial engagement. The financial disengagement that we document among the environmentally engaged households is a challenge for the “people’s capitalism” framework that underpins many discussions concerning the market’s ability to capture pro-social preferences.


Authors: Hao Liang, Lin Sun, Melvyn Teo

This paper sheds light on the investment implications of endorsing the United Nations Principles for Responsible Investment (PRI) by analyzing hedge funds. An integral part of the portfolios of responsible institutional investors, hedge funds are particularly susceptible to agency problems and prone to opportunistic behavior given their low levels of transparency, disclosure, and regulatory oversight.

We show that hedge funds that endorse responsible investment underperform those that do not after adjusting for risk. PRI signatory funds do not underperform because of their greater exposure to responsible firms. Rather, the underperformance is driven by PRI signatories with low exposure to such firms.

Consistent with the agency view, the underperformance of signatory (and low-ESG signatory) funds is stronger when the incentives of fund managers and investors are misaligned. Moreover, in line with the agency story, low-ESG signatories exhibit other forms of managerial opportunism. They are more likely to trigger regulatory, investment, and severe violations, and more likely to display suspicious patterns in reported fund returns that are potential indicators of fraud.

To tackle endogeneity concerns, we show that following the adoption of stewardship codes, which mitigate agency problems, both the ESG exposure and relative performance of signatory funds improve. As an agency story would predict, the results are stronger for low-ESG signatory funds than for high-ESG signatory funds.

We show further that hedge funds that endorse responsible investment reap tangible and pecuniary benefits. Funds that endorse responsible investment attract substantially larger inflows than do other funds. Investors do not on average discriminate between low- and high-ESG signatories. Low-ESG signatories attract investment flow by promoting their funds more aggressively and marketing to unsophisticated investors who are less able to accurately assess ESG exposure.

In an out-of-sample test, we study actively managed mutual funds. Given their higher levels of transparency, disclosure, and regulatory oversight, which curb agency problems, we expect to find weaker results for mutual funds. Nonetheless, for mutual funds with poor incentive alignment, we still find that those managed by signatories (and by low-ESG signatories, especially) underperform, suggesting that agency problems also drive fund underperformance for signatory mutual funds.


1. The moral philosopher Bernard Williams (1973) highlights the difference in the following example. Jim, on a botanical expedition in South America, finds himself in a town square. Twenty natives are tied up against the war and about to be killed for protesting against the government. Since Jim is an honored visitor from another land, the captain offers him the privilege of killing one of the natives himself; if he does so, the other natives will be let off. Even though the “societal return” from killing the native is positive, Jim may choose not to do so due to tastes—he suffers disutility from killing.

NOTE: This and previous issues of Review of Finance [ISSN 1572-3097 | EISSN 1573-692X] are freely available to current EFA members as a benefit of annual membership.  For information on how to submit a manuscript to Review of Finance, please visit the RF Editorial Office website revfin.org.  Follow us on LinkedIn.

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