Financial theory predicts that stocks of “green” or climate-friendly companies should underperform brown ones, but empirical evidence demonstrates that has not been the case. New research explains that paradox, showing that green stocks have had a temporary benefit from adverse climate-related news.
In their 2007 study, “Disagreement, Tastes, and Asset Prices,” Eugene Fama and Ken French explained how investor tastes and preferences for securities can drive valuations and thus expected returns. For example, investors prefer securities with lottery-like distributions. That preference leads those stocks to have higher valuations, with limits to arbitrage preventing sophisticated investors from correcting the overvaluation. The result is that such stocks (i.e., small-cap stocks with high investment and low profitability) tend to have very poor returns.
With the increasing trend by investors toward sustainable investing, Lubos Pastor, Robert Stambaugh and Lucian Taylor, authors of the August 2020 paper, “Sustainable Investing in Equilibrium,” noted that the increased demand for environmental, social and governance (ESG) funds has likely led to a shift in equilibrium. They explained that firms with high ESG scores have rising portfolio weights, leading to short-term capital gains for their stocks – realized returns may rise temporarily, though expected long-run returns fall. Thus, if ESG concerns strengthen unexpectedly, green assets can outperform brown assets despite having lower expected returns.
The higher short-term returns are a result of the increased investor demand on valuations. The authors explained: “Exposure to ESG risk is why green assets may outperform brown assets over a period of time.” Investor tastes/preferences can drive short-term returns through changes in valuations. Thus, the premium induced by exposure to the ESG risk factor can be large enough to overcome green stocks’ negative alphas.
David Ardia, Keven Bluteau, Kris Boudt and Koen Inghelbrecht, authors of the December 2020 study, “Climate Change Concerns and the Performance of Green Versus Brown Stocks,” tested the prediction of Pastor, Stambaugh and Taylor that green firms can outperform brown firms when climate change concerns strengthen unexpectedly for S&P 500 companies. To capture unexpected increases in climate change concerns, they constructed a Media Climate Change Concern (MCCC) index using climate change-related news published by major U.S. newspapers. They retrieved climate change-related news articles from U.S. newspapers for the period January 1, 2003, to June 30, 2018.
They chose newspapers using the 2007 circulation data from the Alliance for Audited Media. They considered high-reaching sources with a daily circulation of more than 500,000 readers . The eight papers that met that condition were The Wall Street Journal, The New York Times, The Washington Post, the Los Angeles Times, the Chicago Tribune, USA Today, the New York Daily News and the New York Post. They aggregated the source data to obtain the MCCC index for the 2010-2018 period studied.
The authors hypothesized that there were five themes that could have an impact on green versus brown stock returns through changes in either cash flow expectations or changes in tastes (preferences): “Financial and Regulation,” “Agreement and Summit,” “Societal Impact,” “Research,” and “Disaster.” They posited that the “Financial and Regulation” theme primarily affects the cash flow channel, the “Research” and “Disaster” themes affect the taste channel, and the “Agreement and Summit” and “Societal Impact” themes affect both channels.
To quantify a firm’s greenness, they relied on the ASSET4/Refinitiv CO2 (carbon dioxide) equivalent greenhouse gas (GHG) emissions data scaled by the firm’s revenue. Thus, the variable measured the number of metric tons of CO2 equivalent GHG emissions necessary for a firm to generate $1 million of revenue, namely, the GHG emissions intensity. Firms whose variable was below (above) the 25th (75th) percentile on a given day were defined as green (brown) firms. Following is a summary of their findings:
- The MCCC index’s spikes corresponded to climate change events, such as the 2012 Doha United Nations Climate Chance Conference or the Paris Agreement and around the days when President Donald Trump announced the U.S. withdrawal from the Paris Agreement. This suggests that the MCCC index captures meaningful events that correlate with real unexpected increases in climate change concerns.
- Stock returns have a positive relationship with the level of GHG emissions intensity – stocks with higher emissions intensity have higher expected returns in the long run.
- When looking at the green (brown) portfolio returns, there was a positive (negative) and significant relationship with the MCCC index. This relationship was stronger in absolute terms for the brown portfolio than for the green portfolio – in case of an unexpected increase in climate change concerns, investors tend to penalize more harshly brown firms than they reward green firms, on average.
- In respect to the five themes that had an effect on green versus brown stock returns, some of those themes can be related to change in investors’ expectations about the future cash flow of green versus brown firms, while others cannot.
- The green minus brown (GMB) portfolio was positively related to the market, size, value and momentum factors and negatively related to both the investment and profitability factors. Thus, the GMB portfolio loads more on large firms with lower growth, aggressive investment policies and weak operating profits. The investment factor coefficient was large, at -0.556, compared to the other coefficients – consistent with the idea that green firms’ capital investment costs are higher than those of brown firms.
- The relationship between concern and green versus brown stock returns arises from both investors updating their expectations about the future cash flows of green and brown firms, and changes in investors’ sustainability taste.
Their findings led the authors to conclude: “We find strong evidence that green versus brown firms’ stock return performance is related to the unexpected increases in climate change concerns. Furthermore, the panel regression results indicate that brown firms tend to outperform green firms when the Media Climate Change Concern is low enough. These results are all consistent with the model of sustainable investing by Pastor, Stambaugh, and Taylor” – empirically validating it.
Larry Swedroe is the chief research officer for Buckingham Strategic Wealth and Buckingham Strategic Partners.
