Diversified ESG Evaluation by Rating Agencies and Net Carbon Tax to Regain Optimal Portfolio Allocation

Abstract

Environmental, Society, and Governance (ESG) investments have become increasingly popular in recent years, and, at the same time, many rating agencies provide ESG scores for each company. This means that the ESG investment model may have moved from the traditional two-factor model of risk-return to a three-factor model adding an ESG component to it. This paper highlights the potential for distortion of asset allocation through the shift from traditional risk-return considerations to ESG score considerations. This is equally true for green bonds, resulting in the potential for asset allocation to be distorted by green bond criteria. Furthermore, we show that imposing a net carbon tax on greenhouse gas (GHG) emissions is a measure to correct this distortion in asset allocation and make asset allocation more risk-return based, in addressing global environmental issues.