Abstract
This paper develops and applies an equilibrium model that accounts for ESG demand and supply dynamics. In equilibrium, ESG preference shocks represent a novel risk source characterized by diminishing marginal utility and positive premium. Expected green asset returns are negatively associated with time-varying convenience yield, while exposures to ESG preference shocks lead to positive green premia. Augmenting these conflicting forces with positive contemporaneous effects of preference shocks on realized returns, the green-minus-brown portfolio delivers large positive payoffs for reasonably long horizons. Nonpecuniary benefits from ESG investing account for a nontrivial and increasing fraction of total consumption.
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