Climate Transition Risk, ESG Rating Divergence and Portfolio Performance: Evidence From Composite Scores and Climate‐Adjusted Factor Models

This study investigates how ESG rating divergences and climate transition risks jointly influence portfolio performance. Using a newly constructed composite Environmental (E) score derived from principal component analysis (PCA) across three leading ESG providers (Eikon, RobecoSAM, Sustainalytics), we build industry-adjusted portfolios for 389 US firms across 10 sectors, including agriculture and industrial sectors. We augment traditional Fama–French factor models with forward-looking climate transition risk proxies, including carbon intensity, stranded asset exposure, sectoral vulnerability (Battiston index) and transition Value-at- Risk (tVaR) under NGFS climate scenarios. Our findings reveal that ESG score disagreements materially affect portfolio construction and return dynamics. After controlling for rating inconsistencies, high-ESG portfolios consistently generate negative alphas relative to low-ESG portfolios, with the economic magnitude of underperformance intensifying as the investment horizon extends from short-to long-term. This underperformance persists even after adjusting for both traditional risk factors and transition-specific risk exposures. The results highlight the importance of harmonising ESG ratings and integrating climate risk measures when evaluating the financial materiality of sustainability investments. The study offers practical implications for institutional investors navigating ESG integration under rising regulatory and climate policy pressures.