The expected returns of ESG excluded stocks. Shocks to firms costs of capital? Evidence from the World's largest fund

Erika Berle, Wanwei (Angela) He and Bernt Arne Ødegaard

Aug 2022

We investigate the consequences of widespread ESG-based portfolio exclusions on the expected returns of firms subject to exclusion. We use the exclusions of Norway's ``Oil Fund'' as a sample of low quality ESG stocks. The fund is the world's largest SWF, whose ESG decisions are viewed as a model for many institutional investors. We construct portfolios representing their exclusions and find that these portfolios have significantly superior performance (alpha). The sheer magnitude of these excess returns (more than 5\% in annual terms) leads us to conclude that low-quality ESG stock has a return premium, as predicted by e.g. Pastor et.al (2021). We also show evidence of the mechanism. Companies with low ESG at the time of exclusion (more scope for improvement), and higher revenue growth (investment needs) are more likely to get their exclusion revoked, which we interpret as evidence of dynamics: Firms improve their ESG to revoke exclusions and achieve lower required returns. In fact, firms that get off the exclusion list do not have superior performance going forward.

Keywords: ESG investing; Exclusion; Cost of Capital

JEL Codes: G10; G20

The paper at SSRN