Greenwashing risk in asset pricing: the shift after the Paris agreement

Factor-based investing has become an increasingly popular strategy among investors. While many proposed factors are based on firm characteristics and economic theory, a rise in environmental, social, and governance focus has spurred the proposal of sustainability factors, such as ESG factors. This growing emphasis on ESG has led to greenwashing emerging as a significant challenge. However, its role as a potential asset pricing factor remains unexplored. This study aims to fill this gap by investigating the explanatory power of greenwashing in the cross-section of asset returns. Using a double-selection LASSO approach and a two-pass regression, we evaluate the contribution of greenwashing as a new asset pricing factor by estimating its stochastic discount factor loading using an extensive global dataset. We further explore its associated risk premium. Our key finding is that in Europe, prior to the Paris Agreement – between 2011 and 2015 – the pair of the stochastic discount factor loading and risk premium for the greenwashing factor is statistically different from zero. This result is robust across alternative factor-portfolio constructions, with greenwashing firms consistently underperforming their genuinely sustainable peers. This suggests that, in an environment lacking uniform ESG disclosure standards, investors treated greenwashing as a systematic information risk factor rather than an idiosyncratic concern. After the Paris Agreement, greenwashing has no significant pricing power, effectively reclassifying greenwashing as a firm-specific risk. These findings suggest that policymakers should strive for clear, consensus-driven ESG regulations to mitigate uncertainty, and that investors can continue to rely on traditional diversification strategies to hedge against the greenwashing risk.