Integrating sustainability risks in asset management: the role of ESG exposures and ESG ratings

The rising sustainability awareness among regulators, consumers and investors results in major sustainability risks of firms. We construct three ESG risk factors (Environmental, Social and Governance) to quantify the ESG risk exposures of firms. Taking these factors into account significantly enhances the explanatory power of standard asset pricing models. We find that portfolios with pronounced ESG risk exposures exhibit substantially higher risks, but investors can compose portfolios with lower ESG risks while keeping risk-adjusted performance virtually unchanged. Moreover, investors can measure the ESG risk exposures of all firms in their portfolios using only stock returns, so that even stocks without qualitative ESG information can be easily considered in the management of ESG risks. Indeed, strategically managing ESG risks may result in potential benefits for investors.