Dynamic ESG Equilibrium

This paper develops and applies an equilibrium model that accounts for ESG demand and supply dynamics. In equilibrium, ESG preference shocks represent a novel risk source characterized by diminishing marginal utility and positive premium. Expected green asset returns are negatively associated with time-varying convenience yield, while positive exposure of unexpected returns to ESG preference shocks imply a positive green premium. Augmenting these conflicting forces with positive contemporaneous effects of preference shocks on realized returns, the green-minus-brown portfolio can deliver large positive payoffs for long horizons. Nonpecuniary benefits from ESG investing account for a nontrivial and increasing fraction of total consumption.