The appetite for environmental, social and governance (ESG) investing has increased rapidly over recent years but the implications for financial markets and asset pricing are far from clear.

Traditionally, an asset price is thought to be a simple yet powerful signal about the present value of future cash flows. However, this view relies on the assumption that all investors only value financial payoffs (e.g., dividends or coupon payments). The presence of ESG investors that value both financial returns and the ESG performance of their portfolios challenges this view. While heterogeneity in financial markets has always existed, this is different – as different investors are valuing an asset for different reasons.

The financial market is populated with two groups of investors that receive informative signals about both components but have distinct preferences about them. Traditional investors value only the financial payoff and green investors value both payoffs. Importantly, these green investors include individual investors that directly value ESG performance alongside ESG fund managers whose compensation and reputation hinge on their ability to identify ESG assets.

As such, asset prices are driven by both factors and may be informative about cash flows and ESG performance.

Since there is only one price to reflect two factors, trading for one factor naturally dilutes useful information contained in the price about the other. For example, the ESG component makes the price a noisier signal about regular cash flows to traditional investors, as they have a hard time understanding whether a high asset price is driven by high future cash flows or good future ESG performance.

This article comes from the UN PRI Academic Blog and was written by Goldstein (University of Pennsylvania); Kopytov (University of Hong Kong); Shen (INSEAD) and Xiang (Peking University). The article provides further details on The green pricing regime.

In this webinar we will bring together a panel of wide experience in this area – from ESG investing and market pricing. Join this panel discussion to have your burning questions answered.