ESG factor emerges as a new risk factor in Indian equity returns

ESG disclosure has quietly become one of the most debated variables in modern asset pricing, and a new study from the Indian equity market suggests it may deserve a formal seat at the table alongside the classic Fama-French risk factors. Researchers Lipsa Priyadarshani and Nirakar Barik of the Vellore Institute of Technology examined whether environmental, social, and governance scores carry incremental explanatory power for portfolio returns in one of the world’s fastest-growing emerging markets. Their findings, published in Frontiers in Sustainability, indicate that ESG is not merely a marketing label but a measurable factor that complements, rather than replaces, the traditional size and value effects that have anchored equity research for decades.

The study arrives at a moment when responsible investing has moved from niche to mainstream. Since the United Nations Principles for Responsible Investment were introduced in 2005, the movement has spread across 50 countries and 1,400 firms, creating structural definitions for ESG ratings that now shape trillions of dollars in capital allocation. India has been a particularly interesting laboratory for this transition. The Securities and Exchange Board of India progressively mandated Business Responsibility Reports for the top 100, 500, and 1,000 listed companies between 2012 and 2019, and in 2021 introduced the more stringent Business Responsibility and Sustainability Reporting framework. This regulatory evolution created a natural experiment: a market where ESG disclosure became compulsory for a large cross-section of firms, allowing researchers to test whether sustainability information actually prices into stock returns.

Priyadarshani and Barik used the Nifty 500 index as their sample, which encompasses large, mid, and small capitalization firms representing roughly 90 percent of total Indian market capitalization. Their data span April 2015 to March 2023, a period chosen because SEBI required the top 500 firms to report ESG scores from 2015 onwards. All data were sourced from the Bloomberg database, with month-end adjusted closing prices, market capitalization as a proxy for firm size, and price-to-book ratios as the value factor. The risk-free rate was approximated using the yield on 91-day Treasury bills from the Reserve Bank of India, while market returns were proxied by the Nifty 200 index, which covers about 80 percent of market capitalization on the National Stock Exchange.

A key methodological innovation was the use of Zero-Centered scores to measure peer-relative ESG performance. Rather than relying on raw ordinal ESG ratings, the researchers calculated the difference between a firm’s ESG score and the median ESG score of its peer group from the prior fiscal year, with the median floored at 1.5 to prevent distortion in years when overall market ESG scores were very low. This approach captures not only a firm’s relative position but also the magnitude of its sustainability outperformance or underperformance, allowing returns to be interpreted on a consistent scale across the sample. The procedure was applied separately to the individual ESG components of environment, social, and governance, and firms with missing ESG scores in a given year were excluded from that year’s median calculation and portfolio formation.

The researchers constructed portfolios using both single-sort and double-sort techniques following the Fama-French methodology. Stocks were ranked annually in June according to market capitalization and classified into five equally-weighted portfolios, with the smallest 20 percent representing small-cap stocks and the largest 20 percent representing large-cap stocks. The same approach was applied to price-to-book ratios, ESG scores, and the individual ESG dimensions. Portfolios were rebalanced each June throughout the sample period, with accounting-based variables and ESG scores taken from fiscal years ending in March and incorporated only from July onwards, ensuring that only information genuinely available to market participants at the time was used and preventing look-ahead bias.

The results reveal strong size, value, ESG, environment, social, and governance effects in the Indian equity market. Small-cap portfolios consistently outperformed large-cap portfolios, with annualized mean excess return differentials between the smallest and largest portfolios reaching 20.4 percent for size-value sorts and 28.8 percent for size-ESG sorts. The size-ESG differential was the highest among all portfolio combinations, signifying the importance of the ESG factor in portfolio construction. The mean returns of all explanatory variables were positive, indicating the presence of strong market, size, value, and ESG premiums in the Indian stock market, while the correlation matrix showed all pairwise coefficients below 0.50, suggesting multicollinearity was not a significant concern among the factors.

To test whether ESG carries incremental explanatory power, the researchers compared six regression models: the traditional Fama-French three-factor model, an augmented version replacing the value factor with ESG, modified versions replacing value with the individual environment, social, and governance factors, and a four-factor model incorporating ESG alongside the classic three factors. The four-factor model exhibited superior performance relative to both the traditional and augmented models, as evidenced by higher adjusted R-squared values across the majority of portfolios. For the size-value sorted portfolios, the four-factor model accounted for 96.7 percent of the variation in returns of the smallest, lowest price-to-book portfolio, compared to 96.6 percent under the traditional three-factor model. The alpha estimates were indistinguishable from zero across all portfolio groups, indicating that the models adequately captured average portfolio returns without leaving unexplained abnormal returns.

Among the individual ESG components, the governance factor offered the strongest explanatory power. The modified three-factor model replacing value with governance explained approximately 94.5 percent of the variation in returns of the largest, highest governance portfolio, outperforming the specifications based on environment or social factors. This finding aligns with international evidence from the US and European markets, where governance characteristics have been shown to play a relevant role in explaining stock return behavior. The researchers attribute this to the fact that firms typically disclose governance practices more transparently, making such information easier for investors to assess and incorporate into pricing decisions, whereas environmental and social disclosures are often more subjective and dependent on different rating methodologies, reducing their reliability and comparability across firms.

The robustness of the findings was validated through the Gibbons, Ross, and Shanken test, which examines whether the intercepts across asset pricing models are jointly equal to zero. For nineteen out of thirty models, p-values exceeded 0.05, meaning the null hypothesis that intercepts are jointly zero could not be rejected. The four-factor model outperformed the traditional and augmented models as reflected by relatively lower GRS F-statistics and higher average R-squared values across all portfolio combinations, with the exception of the size-ESG sorted portfolios, where the augmented model provided the best description of excess returns. The researchers also re-estimated the regression models using raw ESG scores rather than the Zero-Centered measure, finding results that were not significantly different, which shows the findings are not entirely dependent on the specific score construction.

The implications extend beyond academic curiosity. For institutional investors, mutual fund managers, and asset management firms seeking to incorporate sustainability into their investment approach, the evidence suggests that ESG factors complement rather than replace traditional risk factors in the Indian market. As India attracts more foreign portfolio investment, ESG disclosures may serve as an additional criterion for evaluating firms characterized by strong governance practices, lower risk exposure, and long-term growth prospects. The findings also assist regulators and policymakers in promoting sustainable finance initiatives by improving ESG disclosure standards, transparency, and corporate accountability. The study acknowledges limitations including reliance on a single ESG data provider, potential survivorship bias from using current index constituents retrospectively, and a sample period encompassing the COVID-19 pandemic, but the overall message is clear: in one of the world’s most vibrant emerging markets, sustainability information has become a genuine determinant of equity returns, and investors who ignore it may be leaving both risk management and return opportunities on the table.

Subject of Research: ESG disclosure and portfolio returns: evidence from the Indian equity market

Article Title: ESG disclosure and portfolio returns: evidence from the Indian equity market

Article References: Priyadarshani, L., & Barik, N. (2026). ESG disclosure and portfolio returns: evidence from the Indian equity market. Frontiers in Sustainability, 7, Article 1980440. https://doi.org/10.3389/frsus.2026.1980440

Image Credits: AI Generated

DOI: 10.3389/frsus.2026.1980440

Keywords: ESG investing, Fama-French models, Indian equity market, portfolio returns, sustainable finance, asset pricing, governance factor, emerging markets, disclosure, portfolio, returns, evidence