Carbon Emissions Emerge as a Factor that Explains Returns
Quantitative finance is built on the premise that exposure to factors such as value/growth, market capitalization, momentum and profitability/quality explain the variation of performance of diversified portfolios. New research shows that carbon dioxide emissions represent a new factor.
The evidence of rising temperatures and the renewed policy efforts to curb carbon dioxide (CO2) emissions raises the question of whether carbon emissions represent a material risk today for investors that is reflected in the cross-section of stock returns and portfolio holdings.
Three hypotheses have been offered for the existence of a carbon-emission factor:
One hypothesis is that investors seek compensation for holding the stocks of disproportionately high CO2 emitters and the associated higher carbon risk they expose themselves to, giving rise to a positive relation in the cross section between a firm’s own CO2 emissions and its stock returns. An alternative hypothesis is that markets are inefficient, underpricing carbon risks. Yet a third hypothesis is that stocks of firms with high emissions are like other sin stocks – they are shunned by socially responsible or ethical investors to such an extent that the spurned firms present higher stock returns.
In their 2020 study, “Do Investors Care about Carbon Risk?,” Patrick Bolton and Marcin Kacperczyk found:
- Stocks of firms with higher total CO2 emissions (and changes in emissions) earned higher returns after controlling for the common factors of size, book-to-market and momentum, and other factors (such as low beta and liquidity) and anomalies (such as idiosyncratic volatility and net stock issuance) that predict returns.
- There was also a significant carbon premium associated with the year-to-year growth in emissions – companies that succeed in reducing their emissions can afford to offer lower stock returns, but companies that keep on burning more and more fossil fuels must resign themselves to offering higher returns.
- The carbon premium is economically significant: A one-standard-deviation (SD) increase in the level and change of scope 1 emissions leads to a 1.8% and 3.1% increase, respectively, in annualized stock returns. A one SD increase in the level and change of scope 2 emissions leads to a 2.9% and 2.2% increase in annualized returns. And a one SD increase in the level and change of scope 3 emissions increases stock returns 4.0% and 3.8% on an annualized basis.
- The carbon premium cannot be explained through differences in unexpected profitability or other known risk factors.
Their findings led them to conclude: “Our results are consistent with an interpretation that investors are already demanding compensation for their exposure to carbon emission risk.” Bolton and Kacperczyk’s findings of a carbon risk premium are consistent with economic theory (that risk and expected return are related) and efficient markets.
Motivated by the findings in the above study, Christian Walkshäusl contributed to the literature with his study, “Carbon Momentum,” published in the Fall 2021 issue of The Journal of Impact and ESG Investing, in which he explored how a company’s long-term average carbon emission growth rate, or carbon momentum (CM), impacted expected stock returns and fundamental performance in 22 developed international equity markets. His data sample covered the period July 2008-June 2020 and included an average of almost 1,600 companies per month. His focus was on firms’ longer term average carbon emission growth rates up to five years. He sorted companies into portfolios based on their one-, three- and five-year carbon momentum (CM) and assigned companies each year to three groups: low (bottom 30%), medium (middle 40%) and high (top 30%) based on the given CM distribution. He also split the full period into two subperiods: July 2008-December 2015 and January 2016-June 2020 (the post-Paris Agreement period).
Walkshäusl began by noting: “Companies that continuously grow their carbon emissions are more likely to face increased costs due to stricter regulations and negative customer responses as a result of heightening environmental consciousness.” Following is a summary of his findings:
- On average, companies in the low-CM portfolio reduced their carbon emissions by 13% per year, while companies in the high-CM portfolio increased their carbon emissions by 15% per year. However, their exposure to factors such as size, value, momentum, return on assets, return on equity and market beta were very similar.
- A company’s long-term average CM growth rate was a significant predictor of future stock market and fundamental performance in international equity markets.
- Over the one-, three- or five-year periods, there was a significantly positive relation between CM and expected stock returns over the entire sample period. Investors demand higher expected returns from high-emissions-growth companies, on average, than from low-emissions-growth companies. Measured against factor models, the magnitudes of the high/low return difference ranged from 0.53% to 0.69% per month in the CAPM framework and 0.36% to 0.52% per month using the Fama-French six-factor model – companies paid a price in the form of a higher cost of capital for polluting. The premium was mainly driven by the post-2015 period (a period of increasing concerns over climate risks).
- Investors demanded significantly higher expected returns from high-CM companies than from low-CM companies that continuously reduce their carbon emissions because high CM hurts future fundamental profitability. The positive high/low returns were driven equally by the long and short sides. The CM premium represented a penalty for polluting companies, for which investors demanded higher expected returns; it was a reward for companies that decreased their carbon emissions, as investors were willing to accept lower returns on a risk-adjusted basis.
- The observed CM premium represented a separate source of compensation that is largely unexplained by established financial risk factors of common asset pricing models in the period after the Paris Agreement. Thus, CM held unique information about a company’s carbon emissions behavior that was independent from alternative measures, such as total emissions and emissions intensity.
- High CM had a negative impact on a company’s future fundamental performance after controlling for beta, company size, book-to-market and the current level of profitability. Companies with high CM were penalized with lower future fundamental performance over the whole sample period. Thus, the higher expected returns investors demanded from these companies represented compensation for weaker fundamental performance due to higher exposure to climate-related risks as measured by the CM.
- Alternative carbon indicators (total emissions and emissions intensity) produced insignificant results. Thus, CM emerged as the most relevant carbon-related risk measure.
These findings led Walkshäusl to conclude: “We corroborate the existence of a sizable premium related to carbon risk around the world that extends previous US market evidence. … The observed premium is mainly driven by the period after the 2015 Paris Agreement, which raised awareness for climate-related risks and likewise strengthened the demanded return compensation that remains significantly pervasive after controlling for established risk factors.” He added: “High CM exhibits a significantly negative impact on a company’s future fundamental performance. As CM increases, companies face lower future profitability, as measured by both ROA and ROE. Hence, polluting companies indeed pay a price for doing so that materializes in weaker company fundamentals.”
Larry Swedroe is the chief research officer for Buckingham Strategic Wealth and Buckingham Strategic Partners.
The article above is for informational purposes only and should not be construed as specific investment, accounting, legal, or tax advice. Certain information is based upon third party information which may become outdated or otherwise superseded without notice. Third party information 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® or Buckingham Strategic Partners®, collectively Buckingham Wealth Partners. LSR-21-160