ESG Risk Ratings: Quantitative Insights Benefiting from Size and Sector Adjustments

The past decade has seen a surge in interest in environmental, social, and governance (ESG) issues. Understanding firms’ and portfolios’ exposure to ESG risks is essential. For that purpose, the authors examine the interplay between ESG risk, size, and sector and suggest a straightforward approach for investors to adjust ESG risk scores for size and sector effects. They show examples of portfolios that minimize ESG risk while reducing exposure to size and sectors. The authors also show that there is no free lunch—as investors adjust for size and sector, they are, in effect, constraining their investment universe as well. The suggested adjustments are not specific to size or sector factors but could be applied to any factor.