- Research Article
9
- 10.1016/j.frl.2025.108056
A novel approach to sustainable mean-variance portfolio optimization: Accounting for ESG-related uncertainty
- Nov 01, 2025
- Finance Research Letters
- Lukas Müller + 1 more +1
We develop a robust mean–variance portfolio optimization model that incorporates Environmental, Social, and Governance (ESG) risks under Knightian uncertainty. In this approach, ellipsoidal uncertainty sets constructed from ESG scores capture ambiguity in the assets’ expected returns. Unlike standard ESG portfolio models that impose direct ESG constraints or explicitly integrate the maximization of sustainability into the problem, our formulation naturally shifts the portfolio towards more sustainable assets as ESG uncertainty increases. The resulting optimization problem separates into a classical mean–variance component and an additional ESG-specific penalty term, explicitly quantifying the trade-off between financial performance and sustainability. This trade-off is governed by a single uncertainty-aversion parameter: as it approaches zero, the solution converges to the classical Markowitz portfolio, whereas as it approaches infinity, it converges to a purely ESG-driven allocation. These results demonstrate that accounting for ESG-related Knightian uncertainty can promote sustainable investment decisions without regulatory enforcement, particularly for risk-averse investors. • Our mean–variance portfolio framework leverages ESG ratings to represent uncertainty surrounding future returns, thereby integrating sustainability considerations under conditions of true Knightian uncertainty. • The optimization problem is framed as a worst-case scenario and results in a standard risk-return utility minus an ESG penalty. • This method combines the investor’s financial and sustainability risks aversion into a single uncertainty-aversion parameter. • Zero ESG aversion reproduces the classic Markowitz weights, while extreme aversion makes the allocation follow the raw ESG score ranking. • Rising ESG uncertainty naturally shifts investment toward higher-rated assets, eliminating the need for extra green constraints or regulation. • We show that highlighting the uncertainty associated with ESG risks can shift capital toward greener portfolios and help buffer investors against ESG-driven shocks.
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