Unlocking ESG Premium from Options, Cao et al. (2023)

ABSTRACT

• We find that option expensiveness, as measured by delta-hedged option returns, is higher for low-ESG stocks, indicating that investors pay a premium in the option market to hedge ESG-related uncertainty. We estimate this ESG premium to be about 0.3% per month. All three components of ESG contribute to option pricing. We find that investors pay the ESG premium to hedge jump risks, but not volatility risks. The effect of ESG performance is more prominent during the periods when the attention to ESG is higher and for firms that are more subject to ESG-related risks.

Research target

• Investigate the pricing of uncertainty associated with ESG, by which the authors mean operational, reputational, and/or litigation uncertainty due to poor ESG performance. The study is not so much in the impact of ESG on various risk measures per se but rather in analyzing whether investors recognize these risks and pay a premium,

Methodology

• Event study: Different phases of U.S. regulatory policies in climate change - join, exit, and rejoin Paris Agreement; Other events include Greta Thunberg's speeches and Me-Too movements

• ESG score & option expansiveness (implied volatility, IV) over different phases

• ESG risk premium estimation by Fama-French factor models

Data

• Thomson Reuters ESG Scores: ESG data

• OptionMetrics: Options data

• CRSP: Stock returns, price, and trading volumes

• Compustat: Accounting data

• Thomson Reuters: Institutional holdings (13F) data

• I/B/E/S: Analyst coverage data

• Kenneth French’s data library: Fama-French factors and risk-free rates

• The sample period is from January 2004 to December 2018.

Findings

• A low ESG score is associated with higher ImpVol, revealing that investors pay a premium to hedge against uncertainty associated with poor ESG performance.

• The difference in ImpVol between low- and high-ESG firms amplifies when ESG shocks occur. Following Fama and MacBeth (1973) regressions show that lower ESG scores are associated with lower delta-hedged option returns, suggesting relatively more expensive option prices, even after controlling for common determinants of option returns.

• The difference in average delta-hedged option returns on low- and high-ESG stocks can be regarded as the ESG premium that investors are willing to pay in the option market to hedge against their perceived uncertainty for low-ESG stocks.

• FF-factor models: The magnitude of the risk premium using daily-rebalanced delta-hedged returns is around 0.3% per month.

• A low ESG score is significantly related to higher expected volatility, jump risks, and tail risk, indicating that poor ESG performance magnifies these risks.

• Channel connects ESG score and options markets: business models and product market competition, investors’ attention on ESG, and corporate hedging policy.

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