An Axiomatic Risk-Reward Framework for Sustainable Investing

TL;DR

This paper develops an axiomatic framework for evaluating sustainable investments by integrating environmental, social, and governance (ESG) factors into risk and reward measures, extending traditional financial metrics.

Contribution

It introduces ESG-coherent risk measures and reward-risk ratios based on bivariate functions of financial returns and ESG scores, advancing sustainable investing analysis.

Findings

ESG-coherent risk measures effectively rank stocks based on sustainability.

The framework extends traditional risk-reward measures to include ESG factors.

Empirical analysis demonstrates practical applicability in stock ranking.

Abstract

Continued interest in sustainable investing calls for an axiomatic approach to measures of risk and reward that focus not only on financial returns, but also on measures of environmental and social sustainability, i.e. environmental, social, and governance (ESG) scores. We propose definitions for ESG-coherent risk measures and ESG reward-risk ratios based on functions of bivariate random variables that are applied to financial returns and real-time ESG scores, extending the traditional univariate measures to the ESG case. We provide examples and present an empirical analysis in which the ESG-coherent risk measures and ESG reward-risk ratios are used to rank stocks.