ABSTRACT
This chapter will seek to introduce readers to the rapidly developing concept of ESG risk. It will first educate the reader on what risk premia is, using empirical studies that provide an intellectual basis for the concept. It will then discuss what ESG risk is, and the potential that it provides for risk premia, again using empirical studies which provide a quantitative argument for improved performance and positive tracking error as the result of ESG strategies. This chapter will then highlight why this specific type of risk is relevant to portfolio management. This chapter will also introduce the reader to the concept of ESG rating systems, giving a high-level overview of the most common methods for ESG rating. Rating agencies discussed will be EIRIS (now acquired by Vigeo), KLD (now acquired by MSCI Inc.), MSCI Inc., Sustainalytics, and Thompson Reuters, along with other smaller agencies. This chapter will investigate the correlations between rating agency practices, discuss possible consequences of the consolidation of rating agencies, and critically assess the current subjective foundations of said agencies, with an eye towards developing a standardized methodology for rating ESG criteria. Developments in academic literature on ESG investing and organizations like SASB, the IRRC, and others will be highlighted through this chapter and the case studies therein. This chapter will be structured as an introduction to ESG risk and the development of the ESG rating system, and as such will build on the background of ESG investing discussed in Chapter 2. As such, this chapter will examine the growing perspective amongst investors that ESG investing may present investment risk premia similar to other common risk premia, such as value, momentum, carry, liquidity, and volatility.
