Morningstar - Q2 2021 - 48

Strategies

The Two Sides of ESG Investing
How pecuniary and nonpecuniary ESG can
affect the way investors form portfolios.

QUANT U

Paul D. Kaplan
Environmental, social, and governance factors
are being greatly emphasized in investing these
days. Unfortunately, there is some confusion
about what it means to incorporate ESG into the
investment process. This is because there are
two sides of ESG that must be kept distinct when
building a portfolio:
1 Pecuniary ESG This is the impact that ESG
factors have on the risk and expected return of
securities issued by a company.1
2 Nonpecuniary ESG This is the impact that ESG

factors have on how desirable investors
find securities apart from risk and expected
return. For example, investors may prefer
stocks issued by green companies because of
their personal values and concerns about
the environment.2
In this issue of Quant U, I present a framework
for understanding how both pecuniary and
nonpecuniary ESG can have an impact on
how investors form portfolios in an equilibrium3
setting using an ESG-specific version of the
popularity asset pricing model, or PAPM, which

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I have discussed in previous issues of Morningstar
magazine.4 The model I present here is similar to
one in the academic literature on ESG.5
Equilibrium with Pecuniary ESG Views and
No Nonpecuniary Preferences
According the PAPM, investors can form
portfolios based on pecuniary factors (risk and
expected return) and possibly any number
of nonpecuniary factors. Furthermore, investors
can have different views regarding pecuniary
factors. In the ESG version of the PAPM
I discuss here, I assume that investors have
one of two pecuniary views: ESG-unaware
and ESG-aware.6 For now, I assume that
no investors have nonpecuniary preferences,
but I will introduce those who do into the
model later.

To model the impact of investors having
different ESG views, I formed a simple model in
which there are two stocks (ESG-positive
and ESG-negative) and two investors (ESGunaware and ESG-aware).
The PAPM is an extension and generalization of the
capital asset pricing model, or CAPM.7 Both
the CAPM and the PAPM are single-period models
in which investors trade securities (stocks and
cash) at the beginning of the period and receive

the payouts of the stocks at the end of the
period. In the ESG-unaware view, I assume that
the two stocks have the same expected payout
but differ in the standard deviations of their
payouts as well as in their systematic risks (betas).
I assume that the ESG-positive stock has both
greater total and systematic risk, so that it is both
riskier and has a greater expected return than
the ESG-negative stock.
I assume that the ESG-positive stock is issued
by a company with good ESG practices
that contribute to its expected payout being
greater than that in the ESG-unaware view.
Similarly, I assume that the ESG-negative
stock is issued by a company with poor ESG
practices that contribute to its expected
payout being less than that in the ESG-unaware
view. The ESG-aware view takes the ESG
practices of both companies into account, while
the ESG-unaware view ignores them, leading
to a less accurate estimate of expected payout.
To keep the example symmetric, I subtract
the same amount from the ESG-negative
stock's expected payout as I add to the expected
payout of the ESG-positive stock.
I assume that both investors have no nonpecuniary
preferences and identical pecuniary preferences
for risk and expected return (that is, the same
risk tolerance). Hence, as in the CAPM, each
investor seeks to maximize risk-adjusted expected
return.8 I also assume that they have equal
amounts of capital.
EXHIB IT 1 shows the expected returns and
standard deviations of the stocks and investor
portfolios under equilibrium under both
the ESG-unaware and ESG-aware views. Under
both views, the ESG-positive stock has the
same standard deviation but a higher expected

The Sustainalytics ESG Risk Rating, which is the basis for the Morningstar Sustainability Rating for Funds (the globe rating) is a pecuniary ESG rating.
The Sustainalytics ESG Rating, which is distinct from the ESG Risk Rating, is a pecuniary ESG rating.
An asset market is in equilibrium when the prices are such that the demand for each asset matches its supply. I assume this is the case throughout this article.
In Kaplan (2018a) and (2018b), I discuss the PAPM as presented in Ibbotson, Idzorek, Kaplan, and Xiong (2018). See also Rekenthaler (2019). In Kaplan (2019), I discuss PAPM with
heterogeneous expections as presented in Idzorek, Kaplan, and Ibbotson (2020).
This is Pedersen, Fitzgibbons, and Pomorski (2020, hereafter PFP). PFP present a PAPM-like model with both pecuniary and nonpecuniary ESG.
I adopted this terminology from PFP.
Alternatively, we can say that the CAPM is a special case of the PAPM in which everyone has the same expectations and no additional preferences beyond risk aversion.
2
I am using risk-adjusted expected return as a descriptive term for an investor's utility function in the CAPM. This is U( ) = - 12 , where µ is the expected return of the investor's
portfolio, is the standard deviation of return on the investor's portfolio, and is the investor's risk aversion coefficient.

48

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