ESG, a work in progress

According to a new study, “green” stocks have outperformed “brown” stocks since 2010.

This may be due to increased demand from investors with an environmental, social, and governance (ESG) mandate, implying that the impact is only temporary and that brown stocks now have higher expected returns.

The evidence of rising temperatures, as well as renewed policy attempts to reduce carbon dioxide (CO2) emissions, raises the issue of whether CO2 emissions are a material risk for investors, as evidenced by stock returns across the board.

With their June 2019 report, “Carbon Risk,” Maximilian Görgen, Andrea Jacob, Martin Nerlinger, Ryan Riordan, Martin Rohleder, and Marco Wilkens add to the literature on the effect of carbon risk on asset pricing.


They calculated carbon risk using data from four major ESG databases and a “Brown-Minus-Green factor” (BMG) derived from 1,600 companies.


This factor enabled the estimation of carbon risk, which they described as the vulnerability of stock prices to changes in carbon-related emissions.


Their Brown-Green Score (BGS) is a combination of three metrics that are intended to capture the exposure to carbon risk of firms’ “value chains” (e.g., actual emissions), “public perception” (e.g., reaction to perceived emissions), and “adaptability” (e.g., response to perceived emissions) (e.g., mitigation strategies).

Due to a lack of evidence, which is an issue for all ESG-related studies, their data sample only spanned the years 2010 to 2017. Here’s a rundown of what they discovered:

1) Green companies are becoming considerably greener than brown firms, which is driving the trend. Green companies, for example, decreased their average carbon intensity by roughly 16 percent per year, compared to roughly 2 percent per year for brown firms.

2) The BMG factor improves the explanatory power of popular asset pricing models, implying that it is essential in understanding global equity price variance.

3) Brown firms outperformed green firms on average (those with a higher BGS).

4) If a company surprised the market by being browner (having a higher BGS score) than the previous year, it did worse.

5) Firms that invest in innovation and clean technology, as measured by R&D investments, had lower carbon betas than those with dirty or “stranded” properties, as measured by land, plant, and equipment assets.

6) The financial industry’s carbon risk is closely linked to the carbon risk of the domestic companies it is likely to fund.

7) The gap in returns between brown and green firms was around 14%, with green firms outperforming brown firms. This is consistent with the increased market interest in addressing climate change, which has resulted in increased demand for green company stocks and decreased demand for brown company stocks – the increased demand explains why green companies outperformed brown companies, which contradicts the economic theory.

8) With equivalent exposures to other systematic risk factors (such as beta, scale, and value) or to particular industries, investors may achieve comparable projected returns and Sharpe ratios for their portfolios while reducing carbon beta using a “best-in-class” strategy. Thus, demonstrating that by allocating their portfolios to companies with high scores but equal exposure to other common variables, investors can achieve their long-term investment objectives without sacrificing returns.

9) Carbon betas are strong in countries like South Africa, Brazil, and Canada, implying that if the world accelerates the transition to a low-carbon economy, those countries will be negatively impacted.

10) In Europe and Japan, on the other hand, average carbon betas are negative. Carbon betas in the tech industry are near zero on average, while carbon betas in the basic materials and energy industries are the largest, as predicted. However, carbon betas vary significantly across industries, implying that carbon risk is not simply a proxy for the risk associated with specific industries.

The authors came to the conclusion that the transition from a high-carbon to a low-carbon economy is still underway. As a result, financial markets may not have reached an agreement on new equilibrium stock prices just yet.

“Systematic return differences between brown and green firms may thus represent ongoing re-evaluations of firm fundamentals rather than shifting perceptions about discount rates,” the authors speculated.

“While carbon risk explains systemic return variance well, we do not find proof of a carbon risk premium,” they added in an August 2020 update to their paper.

We show that this is the case because: (1) brown firms and greener firms have opposing price movements, and (2) carbon risk is linked to unpriced cash-flow changes rather than priced discount-rate changes.” Conflicting forces can make it difficult to interpret research findings.

In the short term, there is an uncertain relationship between carbon risk and returns. 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.”

It will take some time before we enter a new equilibrium, given the current trend in sustainable investment. Meanwhile, despite the fact that investors demand a risk premium for carbon risks, green stocks outperform brown stocks.

The contrasting results of this paper and Patrick Bolton and Marcin Kacperczyk’s March 2020 report, “Do Investors Care about Carbon Risk?” Bolton used a longer data set, from 2005 to 2017, while Görgen, Jacob, Nerlinger, Riordan, Rohleder, and Wilkens only looked at data from 2010 to 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.”

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