by Dr Mehrshad Motahari, Research Associate, Cambridge Centre for Finance and Cambridge Endowment for Research in Finance
Green, or environmentally friendly, companies have generated significantly higher stock returns compared to their brown peers in recent years. This gap in the average returns of green and brown stocks was more pronounced during the first COVID-19 (coronavirus) wave last year, when the market crashed (Albuquerque et al., 2020). Theoretically, however, this ‘green premium’ seems counter-intuitive. Instead, brown companies should generate greater returns to compensate for their higher levels of climate risk. This is because brown companies are not only exposed to physical damages caused by their environmentally unfriendly practices but are also facing immense social and regulatory pressure to transition to more sustainable entities. This blog post looks at two recent studies by Pástor et al. (2021a; 2021b) in order to explain why green stocks have outperformed and how this is consistent with the theory.
Pástor et al. (2021b) elegantly posit how environmental friendliness should be linked to stock returns using an equilibrium model. The unique aspect of this model is that it accounts for investors’ preferences for sustainability, in addition to climate risk exposure, as forces that shape the returns of green stocks. Specifically, investors in this setting derive utility not just from financial wealth but also from the social impact of holding green companies. The implication of this preference for green holdings is that investors are willing to pay more for greener stocks, resulting in lower expected returns of these stocks in the cross-section. In equilibrium, stock returns vary by exposure to a systematic green factor that captures investors’ demand and appreciation for green investments at each point in time.
There is recent empirical evidence in support of Pástor et al. (2020)’s model. For example, Bolton and Kacperczyk (2021) use carbon emissions to classify firms into green and brown and show that firms with higher emissions generate higher stock returns. More importantly, they find that this result appears only in recent years, particularly after the Paris Agreement, which attracted investors’ attention to climate change. However, a large number of studies that use different environmental-friendliness measures, such as environmental, social and governance (ESG) ratings, report contradictory findings. Atz et al. (2021) conduct a meta-analysis of more than 1,000 research papers and find that the vast majority of these studies report a positive relationship between ESG and measures of financial performance, including stock returns.
Pástor et al. (2021a) reconcile the puzzling outperformance of green stocks by arguing that their higher realised returns in recent years are due to people’s growing appetite for green practices. This unanticipated increase in investors’ demand for the stock and consumers’ demand for the products of green companies has increased their market value, as captured by higher returns. However, this does not mean that green companies will generate higher expected returns going forward. Pástor et al. (2021a) establish this by showing that green companies only outperform when there is a shock related to bad climate news. After accounting for climate-concern shocks and sustainable fund flows in response to them, green stocks underperform brown ones.
Although Pástor et al. (2021a) present an intuitive picture regarding the recent performance of green stocks, further research is needed to understand how this will develop in the future and affect other areas of the market. Particularly, we do not know how much longer it takes for investors’ preferences to adjust so that we observe a consistent premium associated with climate risks. In fact, green stocks may still outperform in years to come as investors experience new climate-concern shocks. This can have consequences in other areas. As one example, Pástor et al. (2021a) show that part of the reason value stocks performed poorly in recent years is that most of them happen to be brown stocks. There may be other more specific implications that remain to be explored.
Albuquerque, R., Koskinen, Y., Yang, S. and Zhang, C. (2020) “Resiliency of environmental and social stocks: an analysis of the exogenous COVID-19 market crash.” The Review of Corporate Finance Studies, 9(3): 593–621
Atz, U., Van Holt, T. and Liu, Z. (2021) “Do corporate sustainability and sustainable finance generate better financial performance? A review and meta-analysis.” SSRN
Bolton, P. and Kacperczyk, M. (2021) “Do investors care about carbon risk?” Journal of Financial Economics
Pástor, Ľ., Stambaugh, R.F. and Taylor, L.A. (2021a) “Dissecting green returns.” National Bureau of Economic Research
Pástor, Ľ., Stambaugh, R.F. and Taylor, L.A. (2021b) “Sustainable investing in equilibrium.” Journal of Financial Economics (forthcoming)