Economic theory says that “green” stocks – those of companies with a low carbon footprint – should underperform “brown” ones. But in recent years that has not been the case, and new research explains how cash flows to sustainable strategies have driven short-term outperformance.
In the face of accelerating climate change, investors are making capital allocations seeking to decarbonize portfolios by reducing the carbon intensity of their holdings. Alexander Cheema-Fox, Bridget Realmuto LaPerla, George Serafeim, David Turkington and Hui (Stacie) Wang contribute to the sustainable-investing literature with their study, “Decarbonization Factors,” published in the fall 2021 issue of The Journal of Impact and ESG Investing. They examined whether institutional flows to decarbonization strategies affect returns as investors incorporate information about climate change into their investment processes.
Their data sample spanned the period June 30, 2009-December 31, 2018, for the United States and Europe. They constructed decarbonization factors that were industry neutral and went long low-carbon-intensity and short high-carbon-intensity sectors, industries or companies with a market cap of at least $2 billion. They classified sectors, industries or companies into high or low carbon emissions by the sum of scope 1 and scope 2 carbon emissions over sales. This metric is known as carbon intensity and reflects how carbon efficiently one dollar of revenue is generated. They considered six portfolio formation strategies including rotations across industries and sectors and across companies (best in class). Portfolios were re-formed annually.
Following is a summary of their findings:
- Different strategies produce carbon emissions that vary greatly.
- Strategies that lowered carbon emissions more aggressively performed better (an alpha of about 2%, especially in Europe) – after controlling for traditional factors (market, size, value, momentum, investment and profitability) and the oil return (the return from crude oil on the futures market). Decarbonization factors that achieve greater carbon reduction also deliver greater alphas.
- Decarbonization factor returns are associated with contemporaneous institutional flows into the factors – buying decarbonization factors when coincident flows are positive while selling when they are negative yields significant alphas – between 1.5% and 4.4% in the United States and 2.5% and 8.5% in Europe over the sample period.
- Combining decarbonization factors without accounting for flows hardly improved portfolio performance in almost all cases.
- Decarbonization strategies had better risk-adjusted performance since 2012 compared to 2009-2011.
- The results were more pronounced in Europe relative to the U.S. This is likely due to Europe having responded more aggressively to climate change by instituting a pricing system for carbon emissions (the European Union Emissions Trading System), which provides more systematic market incentives for businesses to lower their carbon emissions because of stricter carbon regulations and consumers who are generally more sensitive to climate change-related choices.
- The decarbonization factors exhibited strong negative correlation with the investment factor and the profitability factor.
Their results led the authors to conclude: “Institutional investor flows contain information about anticipated fundamentals related to climate change developments.” Their findings are consistent with the economic theory that “brown” stocks have higher expected returns, though “green” stocks can outperform in the short term due to cash flows.
Economic theory
While sustainable investing continues to gain in popularity, economic theory suggests that if a large enough proportion of investors choose to favor companies with high sustainability ratings and avoid those with low sustainability ratings (“sin” businesses), the favored company’s share prices will be elevated and the sin stock shares will be depressed. Specifically, in equilibrium, the screening out of certain assets based on investors’ taste should lead to a return premium on the screened assets.
The result is that the favored companies will have a lower cost of capital because they will trade at a higher price-to-earnings (P/E) ratio. The flip side of a lower cost of capital is a lower expected return to the providers of that capital (shareholders). And the sin companies will have a higher cost of capital because they will trade at a lower P/E ratio. The flip side of a company’s higher cost of capital is a higher expected return to the providers of that capital. The hypothesis is that the higher expected returns (a premium above the market’s required return) are required as compensation for the emotional cost of exposure to offensive companies. On the other hand, investors in companies with higher sustainability ratings are willing to accept the lower returns as the “cost” of expressing their values.
There is also a risk-based hypothesis for the “sin” premium. It is logical to hypothesize that companies neglecting to manage their ESG exposures could be subject to greater risk (that is, a wider range of potential outcomes) than their more ESG-focused counterparts. The hypothesis is that companies with high sustainability scores have better risk management and better compliance standards. The stronger controls lead to fewer extreme events such as environmental disasters, fraud, corruption and litigation (and their negative consequences). The result is a reduction in tail risk in high-scoring firms relative to the lowest-scoring firms. The greater tail risk creates the sin premium.
Conflicting forces
In reviewing the findings of Cheema-Fox, LaPerla, Serafeim, Turkington and Wang, keep in mind that 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 ex post green asset returns even though brown assets earn higher expected returns. In other words, there is an ambiguous relationship between carbon risk and returns in the short term. However, 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 risk premium. The reality is that there was an ex ante carbon premium, but ex post results showed a negative premium because cash flows raised valuations of green companies. Given the continued trend in sustainable investing, it seems likely 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.
Larry Swedroe is the chief research officer for Buckingham Strategic Wealth and Buckingham Strategic Partners.
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Economic theory says that “green” stocks – those of companies with a low carbon footprint – should underperform “brown” ones. But in recent years that has not been the case, and new research explains how cash flows to sustainable strategies have driven short-term outperformance.
