ESG Risk and Market Return Predictability: New Evidence From the Eurozone

ABSTRACT This study examines the predictive power of incident‐based Environmental, Social and Governance (ESG) risk on the Eurozone stock market returns using a forecast combination method. We find that our constructed indicator shows significant return predictability from both a statistical and economic perspective, with an out‐of‐sample CER gain of 4.55% and a Sharpe ratio of 0.43, consistently outperforming the mean benchmark. Moreover, we find that the predictive power is concentrated during non‐expansion periods. We attribute this mechanism to the firm's fundamentals, cash flow and discount rate channels. Our findings highlight the value of ESG information for investors.