ESG, Risk, and (Tail) Dependence

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 ratings. 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, 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 dependencies between clusters determined by ESG scores, especially during the 2008 crisis.