Greenhouse Gas Emissions Have Had No Effect on Profitability or Stock Returns

Advocates of sustainable, or environmental, social and governance (ESG) investing may be disappointed to learn of a new research study showing that greenhouse gas emissions have had no measurable effect on corporate profitability or equity performance.

As background, the popularity of ESG investing, which now accounts for one of every three dollars of total assets under management in the U.S. ($17.1 trillion)[1] and more than half of all European investment dollars, has been accompanied by heightened research into the subject, with more than 1,000 studies published with mixed results. They have found positive, negative and nonexistent correlations between ESG and financial performance. Those inconclusive results may stem from the different underlying ESG data used, the varying methodologies applied (especially insofar as they control for common factor exposures), and the fact that the heightened demand for ESG investments has led to rising valuations of stocks with high ESG scores relative to stocks with low ESG scores. Increased demand has two effects. It leads to short-term capital gains. Ultimately, the higher valuations mean that investors should expect lower future returns over the long term.

In their October 2020 study, “Greenhouse Gas Emissions and Expected Returns,” Wei Dai and Philipp Meyer-Brauns examined how company-level greenhouse gas emissions have been related to company financials as well as the expected returns of the U.S. companies’ stocks (minimum total market capitalization of $50 million and minimum median daily trading volume of $50,000) and bonds (U.S.-dollar denominated corporate bonds from U.S. issuers with S&P credit ratings between AAA and B, and duration between 1 and 10 years) from 2009 to 2018. They began by noting: “As investors seek to incorporate such environmental considerations into their investment decisions, it is important to understand the potential impact of environmental characteristics on firm performance and security returns.” They added: “A stock’s current market value reflects expectations about future cash flows discounted by the expected return. It is plausible that the environmental profile of a firm could impact its expected cash flows.”

Dai and Meyer-Brauns examined the impact of company emissions on stock returns not only on a standalone basis, but also controlling for price variables such as market capitalization and relative price, combined with cash-flow variables such as profitability, which, consistent with valuation theory, are known to contain reliable information about the cross-section of expected stock returns. Following is a summary of their findings: