Statistical Methods in Finance 2025

A General Theory of Sustainable Portfolio Choice and Market Equilibrium under Stochastic Sustainability

By:Dipankar Mondal
IIT, Guwahati

With the increasing frequency of extreme climate events and their devastating impacts on the social and financial health of the global economy, it has become evident that physical climate risk constitutes a major financial risk. A key pathway to mitigating climate-related financial risk is the transition toward a climate-resilient economy through sustainable finance—the integration of environmental and social sustainability into financial decision-making. At the core of sustainable finance lies sustainable investment, which relies on sustainability scores to assess the long-term viability and impact of investment opportunities. This paper develops a general bivariate utility-based theoretical framework for financial decision-making under stochastic sustainability scores. I propose a utility-based portfolio optimization model that incorporates stochastic sustainability. I then analyse market equilibrium under stochastic sustainability and derive a Sustainable Capital Asset Pricing Model. Within this equilibrium, I highlight new properties of the market portfolio, characterize investors’ optimal portfolios, and identify the key determinants of the green–brown spread.