ESG, Risk, and (Tail) Dependence

TL;DR

This paper investigates whether ESG scores can predict a company's risk, especially tail risk, by analyzing dependence structures using vine copula models, revealing that ESG ratings are linked to risk levels, notably during crises.

Contribution

It introduces a high-dimensional vine copula approach to model the dependence between ESG scores and tail risk, providing empirical evidence of ESG risk relevance.

Findings

ESG scores are positively associated with tail risk.

Risk dependence on ESG scores is significant during financial crises.

Vine copula models effectively capture complex dependence structures.

Abstract

While environmental, social, and governance (ESG) trading activity has been a distinctive feature of financial markets, the debate if ESG scores can also convey information regarding a company's riskiness remains open. Regulatory authorities, such as the European Banking Authority (EBA), have acknowledged that ESG factors can contribute to risk. Therefore, it is important to model such risks and quantify what part of a company's riskiness can be attributed to the ESG scores. This paper aims to question whether ESG scores can be used to provide information on (tail) riskiness. By analyzing the (tail) dependence structure of companies with a range of ESG scores, that is within an ESG rating class, using high-dimensional vine copula modelling, we are able to show that risk can also depend on and be directly associated with a specific ESG rating class. Empirical findings on real-world data show positive not negligible ESG risks determined by ESG scores, especially during the 2008 crisis.