Climate Adequacy and Market Risk: Are They Related? Empirical Evidence From the European Equity Market Before and After the Adoption of the Paris Agreement

ABSTRACT ESG ratings, and in particular environmental scores (E‐scores), are becoming increasingly relevant for financial stability and capital allocation decisions. This paper investigates the relationship between corporate environmental performance and market risk, as measured through value at risk (VaR) and expected shortfall (ES), the key metrics used in prudential banking frameworks to assess market risk and determine capital requirements. We also explore whether this relationship has evolved following the Paris Agreement and examine firms' behaviour during periods of financial stress. Using a sample of companies from the STOXX Europe 600 index over the period 2008–2022, we find that the relationship between higher E‐scores and market risk changes significantly over time, becoming negative following the Paris Agreement. Additionally, firms with higher E‐scores display greater resilience during periods of market stress, showing faster adjustments back to pre‐shock conditions. These results imply that banks, investors and asset managers should reorient portfolios towards environmentally sustainable assets to strengthen market resilience and performance. However, the most novel contribution is for policymakers and banking supervisory authorities. The consistent link between higher E‐performance and lower regulatory market risk contributes to the ongoing debate on whether and how sustainability‐related factors should be reflected in prudential regulation, including proposals such as a green supporting factor. Such mechanisms could encourage banks to allocate a greater share of credit to environmentally sustainable activities while maintaining sound risk management standards.