Quantifying Environmental Risk's Impact on Stock Returns

Date of Award

Spring 5-2026

Degree Name

Bachelor of Science (BS)

Advisor(s)

Iris Schneider

Abstract

This research is grounded in the notion that a method for quantifying environmental risk can both enhance its significance as a factor in investment decisions and improve the accuracy of corporate sustainability analysis. Without such, there may be a disconnect in modern investing between acknowledging environmental risk and considering how it affects a company's overall risk portfolio and valuation. Quantifying environmental risk in a way that can be visualized in models enables investors to better understand a company's comprehensive risk profile, which, in turn, facilitates more informed decisions. Thus, this research aims to investigate whether factoring in environmental risk as a quantitative factor enhances the accuracy of stock return predictions. By modifying the Fama & French Three-Factor Model, which is commonly used to explain historical stock returns in terms of risk factors, we can assess whether accounting for environmental risk improves its predictive accuracy. The prediction that the Fama-French model's accuracy could increase with the inclusion of environmental risk suggests that this risk has a tangible, quantifiable effect on stock returns. The results of the experiment indicated that adding an environmental risk variable to the Fama-French model improved the model's ability to explain stock returns. Regression analysis showed a 0.21% reduction in the alpha-intercept and a 4.3% increase in R-squared when an environmental risk factor was included in the model. When testing the model on a diversified portfolio, the beta coefficient for the environmental risk variable was also statistically significant, with a p-value of 0.03. It is possible that the experiment has meaningful implications for the model's efficiency and its inherent ability to quantify environmental risk.

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