Modelling Sustainable Investing in the CAPM

Abstract

Empirical studies investigate various causes and effects of sustainable investments. While some attempts have been made to describe the results found by theoretical models, these are relatively complex and heterogeneous. We relate to existing studies and use a parsimonious Capital Asset Pricing Model (CAPM) in which we model different aspects of sustainable investing. The basic reasoning of the CAPM, that investors need to be compensated for the bad aspects of assets applies so that investors demand higher returns for investments that are harmful from an environmental, social, and governance (ESG) perspective. Moreover, if investors have heterogeneous views on the ESG–characteristics of a company, the market requires higher returns for that company, provided richer investors care more about ESG than poorer investors, which is known as the Environmental Kuznets Curve (EKC). Besides the effect on asset prices, we find that sustainable investing has an impact on a firm’s production decision through two channels – the growth and the reform channel. Sustainable investment reduces the size of dirty firms through the growth channel and makes firms cleaner through the reform channel. We illustrate the magnitude of these effects with numerical examples calibrated to real–world data, providing a clear indication of the high economic relevance of the effects.