Measuring ESG risk premia with contingent claims

We propose a contingent claims approach for estimating ESG risk premia from market information and market participants' decisions. To this end, we infer the asset value dynamics via the structural model of Merton [1974, “On the Pricing of Corporate Debt: The Risk Structure of Interest Rates.” Journal of Finance 29: 449–470.] for a large panel of S&P 500 firms using an estimation algorithm that utilizes the information embedded in stock market prices, CDS spreads, and default probabilities. We find a statistically significant relationship between the ESG score and the volatility and drift terms of the asset value process, suggesting that ESG factors are structurally connected to the value of the firm. We establish a mapping between ESG scores and the cost of equity and debt as implied by firm's contingent claims, and derive estimates of the ESG risk premium across different ESG and leverage profiles. In addition, we break down the ESG risk premia by industry, and demonstrate how practitioners can adjust the weighed average cost of capital of ESG laggard firms for valuation and decision making purposes.