Abstract

This paper evaluates and decomposes the financial and extra-financial impacts of ESG “do no harm” exclusions on equity portfolios. Using two capitalization-weighted indices representative of the Developed Europe and United States equity universes, the study evaluates how exclusions based on each of the United Nations’ sustainable development goals affect tracking error, factor exposure, sector concentration, and carbon intensity. The findings highlight that exclusions associated with social and governance issues, such as anti-competitive practices and internal governance controversies, related to sustainable development goal 8–decent work and economic growth– and 16–peace, justice, and strong institutions–, are the primary drivers of tracking error. Also, we find that the use of optimization techniques to reallocate capital after applying the exclusions effectively mitigates deviations in factor exposures and sector concentration. The impact on carbon intensity is mixed; environmental exclusions reduce carbon intensity, but social and governance exclusions can exclude low-emission companies, leading to unintended increases in carbon footprint. These results emphasize the need for asset owners to tailor exclusion strategies to their sustainability priorities and financial objectives.

Introduction

Exclusion has long been a foundational approach in investment strategies. Its relevance has grown significantly in recent years, particularly within the context of sustainable investing. As a key component of broader sustainable investment strategies, exclusion serves to align portfolios with ethical, social, and environmental standards (Bouchet and Safaee, 2025). At its core, exclusion is often justified on moral grounds, reflecting investors’ desire to avoid profiting from or endorsing activities deemed socially or environmentally harmful. Beyond ethical considerations, a growing body of theoretical literature suggests that exclusion can catalyze meaningful corporate reforms by incentivizing behavioral changes (Heinkel et al., 2001; Pástor et al., 2021; De Angelis et al., 2022). Furthermore, exclusion has been shown to complement and reinforce the implementation of effective climate policies, underscoring its potential to drive systemic change (Braungardt et al., 2019).

The financial impact of ESG exclusion remains a subject of debate in the literature, with findings often conflicting. Some studies, such as Capelle‐Blancard and Monjon (2014) and Trinks and Scholtens (2017), suggest that ESG exclusion reduces financial performance, as controversial stocks tend to offer higherrisk-adjusted returns. In contrast, Khajenouri and Schmidt (2021) report that ESG-screened indices outperformed their benchmarks in terms of risk-adjusted returns over certain periods. This divergence can be attributed to differences in sample characteristics, exclusion criteria, and regional contexts, as highlighted by Plagge (2023).

More recent research has shifted its focus from short-term performance to the risk implications of ESG exclusions. Porteu de la Morandière et al. (2025) conduct for example a comprehensive analysis of 493 indices, encompassing both conventional and sustainable instruments from Europe and the U.S., to assess the financial risks associated with various ESG exclusion strategies. They applied three exclusion screens of increasing restrictiveness—consensus exclusions1, Paris-aligned benchmark standards, and exclusions based on negative contributions to the Sustainable Development Goals (SDGs). Their findings indicate that while the first two screens can lead to significant weight reductions in portfolios, optimized reallocation methods can mitigate tracking error and sector deviations. However, the SDG screen results in significant exclusions and a notable increase in tracking error. For the 128 European indices, the average exclusion for the SDG screen is 58%, compared to just 9% for the consensus screen. Even after optimization, the median tracking error increases to 2.3%, significantly higher than the 0.2% observed for the consensus screen.

The goal of this paper is therefore to investigate how exclusions based on ESG criteria contribute to risk. More specifically, we seek to identify which criteria, or combinations thereof, most contribute to risk, thus establishing the cost of each policy, be it based on themes (Environmental, Social, Governance), subthemes (biodiversity, climate, workforce, consumers, corporate governance and institutional relations), or specific Sustainable Development Goals (SDGs). To achieve this, the analysis focuses on two cap-weighted indices that are representative of the Developed Europe and United States equity stock universes. For each level of ESG exclusion analysis—ranging from individual criteria to overarching themes—the paper examines contributions to excluded weight, tracking error, changes in factor exposure, and portfolio concentration.

Regarding extra-financial impact, Porteu de la Morandière et al. (2025) demonstrate that, despite the substantial share of stocks excluded, the SDG screen does not result in a significant reduction in carbon footprint across the sample of indices analyzed. Although this screen incorporates climate-related criteria, its inclusion of social and governance issues results in the exclusion of companies with very low carbon footprint. Consequently, the impact on the aggregated carbon footprint varies significantly across indices, with no consistent trend towards reduction. To better understand this counterintuitive effect, this study further examines the carbon footprint impact of each individual ESG criterion.

This study identifies three key findings for asset owners wishing to develop sustainable strategies that align with their priorities while managing financial risks. First, social and governance themes are the primary drivers of tracking error in both EU and US indices, with issues such as anti-competitive practices and internal governance generating the most significant deviations. Second, across all exclusion sets, the impact on the risk factor profile and sector concentration remains limited due to the effectiveness of optimized reallocation. Finally, the impact on carbon intensity is mixed; while environmental exclusion sets tend to reduce carbon intensity, social and governance criteria often lead to the exclusion of low-emission companies, thereby increasing the portfolio’s overall carbon footprint.

Authors

Matteo Bagnara, PhD
Quant Researcher,
Scientific Portfolio ……………………………………….
…
….

Shahyar Safaee
Deputy CEO and Business Development Director,
Scientific Portfolio

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