Liquidity Effects of Shifts in Market Greenness and Implications for Asset Pricing

• Market greenness predicts Pástor-Stambaugh liquidity innovations in 2015-2019 • New liquidity measure links market ESG performance to stock returns • ESG-related liquidity is not spanned by well-established risk factors • ESG-related liquidity lowers pricing errors versus Pástor-Stambaugh before 2020 • Mechanism evidence ties greenness-liquidity predictability to ESG demand Building on the Pástor-Stambaugh liquidity measure and an equilibrium model that incorporates investors’ ESG preferences, we show that market greenness predicts liquidity shocks during periods plausibly associated with shifts in investors’ ESG tastes. Moreover, forecasts of ESG-related liquidity from our model reduce stock alphas more effectively than the Pástor-Stambaugh liquidity measure over the period in which market greenness predicts liquidity. We also show that ESG-related liquidity contains information not captured by other well-established risk factors. Overall, our results are consistent with shifts in investors’ ESG tastes generating alphas unexplained by classic risk factors, which are partially captured by ESG-related liquidity.