Final answer:
To adjust the cost of equity to include ESG factors, investors account for the risks and potential impacts of ESG on financial performance by using ESG integration methods and adjusting cost of capital models to reflect these considerations.
Step-by-step explanation:
Adjusting the cost of equity to incorporate Environmental, Social, and Governance (ESG) factors involves accounting for the risk and potential impact these factors may have on a company's financial performance. Companies with strong ESG practices may be considered lower risk and possibly warrant a lower cost of equity, reflecting the perception that they are better prepared to handle future ESG-related challenges. Conversely, companies with poor ESG practices might be assigned a higher risk premium.
To adjust the cost of equity for ESG factors, investors can use ESG integration methods or ESG-adjusted financial models, which might involve modifying the inputs for calculating the weighted average cost of capital (WACC), such as adjusting beta to reflect potential ESG risks or considering ESG ratings from reputable agencies.