Responsible investing: The ESG-efficient frontier

TLDR

The authors propose a theory where a stock’s ESG score informs firm fundamentals and shapes investor preferences. They model equilibrium asset prices with an ESG‑adjusted CAPM, compute the empirical ESG‑efficient frontier from large datasets, and test predictions using ESG proxies. The study finds an ESG‑efficient frontier that delivers the highest Sharpe ratio for each ESG level, with portfolios obeying four‑fund separation, and empirical analysis reveals the costs and benefits of responsible investing.

Abstract

We propose a theory in which each stock's environmental, social, and governance (ESG) score plays two roles: (1) providing information about firm fundamentals and (2) affecting investor preferences. The solution to the investor's portfolio problem is characterized by an ESG-efficient frontier, showing the highest attainable Sharpe ratio for each ESG level. The corresponding portfolios satisfy four-fund separation. Equilibrium asset prices are determined by an ESG-adjusted capital asset pricing model, showing when ESG raises or lowers the required return. Combining several large data sets, we compute the empirical ESG-efficient frontier and show the costs and benefits of responsible investing. Finally, we test our theory's predictions using proxies for E (carbon emissions), S, G, and overall ESG.