This article was edited on June 6, 2021, to correct a few errors: the data sample was from 2010 to 2016; brown firms did not outperform green firms; and a bullet point was added about the strong contrast between brown and green stock performance.
New research shows that, since 2010, “green” stocks – those of companies with a low carbon footprint – have outperformed “brown” stocks. That may have been caused by increased demand from investors pursuing an environmental, social and governance (ESG) mandate, which means the effect is temporary and brown stocks now have higher expected returns.
The evidence of rising temperatures and the renewed policy efforts to curb carbon dioxide (CO2) emissions raises the question of whether those emissions represent a material risk for investors that is reflected in the cross-section of stock returns. This important question has led to a heightened interest in the subject from researchers and a flurry of new papers.
Maximilian Görgen, Andrea Jacob, Martin Nerlinger, Ryan Riordan, Martin Rohleder and Marco Wilkens contribute to the literature on the impact of carbon risk on asset pricing with their June 2019 study, “Carbon Risk.” They quantified carbon risk via a “Brown-Minus-Green factor” (BMG) derived from 1,600 firms with data from four major ESG databases. This factor allowed the estimation of carbon risk, using what they defined as “carbon beta,” which is the sensitivity of stock prices to changes in carbon-related emissions. Their Brown-Green Score (BGS) is a composite measure of three indicators designed to separately capture the sensitivity to carbon risk of firms’ “value chains” (e.g., current emissions), “public perception” (e.g., response to perceived emissions) and “adaptability” (e.g., mitigation strategies). Due to limited data availability, a problem with all ESG-related research, their data sample covered the relatively short period 2010 to 2016. Following is a summary of their findings:
- Firms are becoming greener – mostly driven by green firms becoming significantly greener than brown firms. For instance, green firms reduced their average carbon intensity by roughly 16% annually versus roughly 2% annually for brown firms.
- The BMG factor significantly increases the explanatory power of common asset pricing models, suggesting it is important in explaining variation in global equity prices.
- Firms performed worse if they surprised markets by becoming browner (their BGS score rises) compared to the previous year.
- Firms investing in innovation and clean technology, proxied by R&D expenditures, had lower carbon betas, while firms with dirty or “stranded” assets, proxied by property, plant and equipment assets, had higher carbon betas.
- The carbon risk of the financial industry is strongly related to the carbon risk of the domestic firms they are likely to finance.
- There was a strong contrast in the performance of the brown and the green portfolio over time. While the cumulative return of BMG was slightly positive in the period from 2010 to the end of 2012, the effect reversed in the following period and over the full period brown firms performed worse than green firms on average during our sample period.
- The cumulative difference in returns between brown and green firms was roughly 14%, with green firms outperforming. This is consistent with increased investor focus on tackling climate change, which has led to increased demand for the stocks of green firms and reduced demand for the stocks of brown firms – the increased demand explains why green firms outperformed brown firms, which is inconsistent with economic theory.
- Investors can achieve comparable expected returns and Sharpe ratios for their portfolios with similar exposures to other systematic risk (such as beta, size and value) factors or to specific industries while reducing carbon beta via a “best-in-class” approach – demonstrating that investors can achieve their sustainable investing goals without sacrificing returns by tilting their portfolios to companies with good scores but with similar exposure to other common factors.
- Carbon betas are high and positive in countries like South Africa, Brazil and Canada, which means those countries will likely be negatively affected if the world speeds up the transition to a low-carbon economy. In contrast, average carbon betas are negative in European countries and Japan. On an industry level, tech firms have carbon betas near zero on average, while basic material and energy firms have the highest positive carbon betas, as expected. There are, however, significant differences in carbon betas within industries, suggesting that carbon risk is not simply a proxy for the risk associated with certain industries.
Their findings led the authors to conclude that the transition from a high-carbon to a low-carbon economy is ongoing. As a result, capital markets may not yet agree upon new equilibrium equity prices. The authors stated, “systematic return differences between brown and green firms may thus reflect ongoing re-evaluations of firm fundamentals rather than changing expectations regarding discount rates.” In an August 2020 update of their paper, they added: “While carbon risk explains systematic return variation well, we do not find evidence of a carbon risk premium. We show that this may be the case because of: (1) the opposing price movements of brown firms and firms becoming greener, and (2) that carbon risk is associated with unpriced cash-flow changes rather than priced discount-rate changes.” The conflicting forces can create problems in interpreting research findings.
Conflicting forces
Investor preferences lead to different short- and long-term impacts on asset prices and returns. Firms with high sustainable investing scores earn rising portfolio weights, leading to short-term capital gains for their stocks – realized returns rise temporarily. However, the long-term effect is that higher valuations reduce expected long-term returns. The result can be an increase in green asset returns even though brown assets will earn higher expected returns. In other words, there is an ambiguous relationship between carbon risk and returns in the short term. As the authors noted: “Over time as the markets develop a better understanding of carbon risk and the unexpected component falls relative to the expected component, we should expect a positive relationship between returns and carbon risk.” Without this understanding, investors can misinterpret findings that appear to show the lack of a carbon premium. There was an ex-ante carbon premium, but the ex-post results showed a negative premium because of cash flows raising valuations of green companies. Given the continued trend in sustainable investing, it will be a while before we reach a new equilibrium. In the meantime, despite investors requiring a risk premium for carbon risks, green stocks can outperform brown ones.
The difference in the impact of ESG-related demand on short-term and long-term returns helps explain the conflicting findings of this paper and that of Patrick Bolton and Marcin Kacperczyk, authors of the March 2020 study, “Do Investors Care about Carbon Risk?” Bolton used a longer data series, spanning 2005 through 2017, while the study by Görgen, Jacob, Nerlinger, Riordan, Rohleder and Wilkens covered only the period 2010 through 2017. Bolton and Kacperczyk found an economically significant carbon premium and concluded: “Our results are consistent with an interpretation that investors are already demanding compensation for their exposure to carbon emission risk.” They noted that the carbon premium has only materialized recently: “We show that if we look back to the 1990s by imputing the 2005 cross-sectional distribution of total emissions to the 1990s, there is no significant carbon premium, consistent with the view that investors at that time likely did not pay as much attention to carbon emissions.”
The differences in findings can be explained by the dramatic increase in ESG-related demand in the latter half of the period studied by Bolton and Kacperczyk, the only period covered by Görgen, Jacob, Nerlinger, Riordan, Rohleder and Wilkens. The effect of those cash flows on valuations swamped the carbon premium demanded by investors – the new equilibrium had not been reached.
Larry Swedroe is the chief research officer for Buckingham Strategic Wealth and Buckingham Strategic Partners.
Important Disclosure: The information contained in this article is for educational purposes only and should not be construed as specific investment, accounting, legal or tax advice. The analysis contained in this article is based upon third party information available at the time which may become outdated or otherwise superseded at any time without notice. Certain third-party information is based upon is deemed to be reliable, but its accuracy and completeness cannot be guaranteed. By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party websites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them. The opinions expressed by featured authors are their own and may not accurately reflect those of the Buckingham Strategic Wealth®, Buckingham Strategic Partners® (collectively Buckingham Wealth Partners). LSR-21-27
`
More ESG Topics >
This article was edited on June 6, 2021, to correct a few errors: the data sample was from 2010 to 2016; brown firms did not outperform green firms; and a bullet point was added about the strong contrast between brown and green stock performance.