Incorporating ESG Factor into Asset Pricing: Effectiveness Assessment in Australian Market

Abstract

Traditional asset pricing models such as CAPM and Fama-French Multiple Factor Models have been widely used in stock valuation. However, these models have faced challenges in providing sufficient explanatory power to stock returns, especially with the rising awareness on non-financial factors in investment decision-making. This paper examines the effectiveness of the asset pricing model in Australian market, which incorporates the ESG factor into Fama-French Five Factor Model. Through implementing regression analysis on a sample of 25 Australian-listed companies, each representing a distinct Global Industry Classification Standard (GICS) industry group, the findings indicate that the ESG factor significantly contributes to explaining stock returns in most industries, meanwhile still maintaining the explanatory power of traditional factors. However, the study also finds that ESG beta is insignificant in industries where ESG concerns are of lower priority. These results underscore the increasing importance of ESG considerations in investment analysis, particularly in industries where sustainability and ethical considerations play a central role. The findings provide insights for investors, policymakers, and researchers, suggesting that ESG factors should be integrated into asset pricing models to enhance their predictive capabilities.