The Art of Linking ESG Scores to Stock Return and Volatility

Abstract

This study investigates the impact of Environmental, Social, and Governance (ESG) scores on the financial performance of US stocks from 2010 to 2022. By analyzing data sourced from Refinitiv, Bloomberg, Compustat, and CRSP, we examine the relationship between ESG scores, stock returns, and risk metrics. The methodology involves Ordinary Least Squares (OLS) and Fixed Effects (FE) regression models to control for various variables and address issues like mul-ticollinearity and heteroskedasticity. The study struggles to reveal a statistically significant correlation between ESG scores and stock returns. When analyzed separately, individual ESG pillars did not show significant correlations with stock returns either. Additionally, ESG scores were found to negatively correlate with volatility, suggest-ing that firms with higher ESG scores exhibit reduced risk. However, this correlation does not extend to superior risk-adjusted returns, as evidenced by the Sharpe Ratio analysis. The study highlights the complexity and mixed results in the relationship between ESG scores and financial performance, underscoring the need for standardization in ESG rating methodologies to reduce investment uncertainty and enhance the utility of ESG scores in investment strategies. These findings contribute to the ongoing discourse on ESG investing, pro-viding insights for investors and policymakers in the sustainable fi-nance domain.