Investors underestimate the negative consequences of high environmental, social and governance (ESG) risks, and underreact to prior negative ESG events. High ESG risks destroy shareholder value.

To appreciate the significance of this finding, consider that, over the past decade, there has been an accelerating increase in ESG investing strategies. In fact, ESG investing in its various forms (such as SRI, or socially responsible investing) now accounts for one out of every four dollars under professional management in the United States and one out of every two dollars in Europe. And the trend seems poised to continue. The Global Sustainable Investment Alliance 2018 Review, which covers the five regions of Europe, the United States, Canada, Japan, and Australia and New Zealand, showed that sustainable investing assets in those major markets stood at $30.7 trillion at the start of 2018, a 34% increase in two years. And responsible investment commanded a sizable share of professionally managed assets in each region, ranging from 18% in Japan to 63% in Australia and New Zealand.

The following table from the report shows how investor assets are allocated across various ESG strategies. he largest share is still in negative/exclusionary screening (the exclusion from a fund or portfolio of certain sectors, companies or practices based on specific ESG criteria) as opposed to ESG integration (the systematic and explicit inclusion by investment managers of environmental, social and governance factors into financial analysis).

The report also noted that, “the leading motivation, based on the number of money managers citing it and the assets they represent, is client demand.” Among the other main motivations cited were the desire to achieve social and environmental benefit or to fulfill their firms’ missions.

Increased investor interest has not only led to cash inflows but to heightened interest in research on ESG investment strategies and the impact of those cash flows on returns. The hypothesis is that the incorporation of ESG characteristics in investment decisions can impact expected returns by reflecting investor preferences or by loading on some underlying risk factor. Either way, they suggest a likely ESG premium on expected returns because lower demand should lead to systematically lower valuations. And even if responsible firms encounter higher operating costs, investors’ preferences for ESG may make them willing to invest in such firms despite lower expected returns.