Identifying Risk Variables From ESG Raw Data Using A Hierarchical Variable Selection Algorithm

Abstract: Environmental, Social, and Governance (ESG) factors aim to provide non-financial insights into corporations. In this study, we investigate whether we can extract relevant ESG variables to assess corporate risk, as measured by logarithmic volatility. We propose a novel Hierarchical Variable Selection (HVS) algorithm to identify a parsimonious set of variables from raw data that are most relevant to risk. HVS is specifically designed for ESG datasets characterized by a tree structure with significantly more variables than observations. Our findings demonstrate that HVS achieves significantly higher performance than models using pre-aggregated ESG scores. Furthermore, when compared with traditional variable selection methods, HVS achieves superior explanatory power using a more parsimonious set of ESG variables. We illustrate the methodology using company data from various sectors of the US economy.