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:

Three hypotheses

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.