A large body of academic research attempts to explain the cross-sectional pattern of stock returns based on exposures to factors such as size and value, profitability/quality, and momentum. One variable that has so far been missing from the analysis is corporate carbon emissions. The evidence of rising temperatures and the renewed policy efforts to curb carbon dioxide (CO2) emissions raises the question of whether carbon emissions represent a material risk today for investors that is reflected in the cross-section of stock returns and portfolio holdings.
One hypothesis is that investors seek compensation for holding the stocks of disproportionately high CO2 emitters and the associated higher carbon risk they expose themselves to, giving rise to a positive relation in the cross-section between a firm’s own CO2 emissions and its stock returns. An alternative hypothesis is that markets are inefficient, underpricing carbon risks. Yet a third hypothesis is that stocks of firms with high emissions are like other “sin stocks” – they are shunned by socially responsible, or ethical, investors to such an extent that the spurned firms present higher stock returns.
Patrick Bolton and Marcin Kacperczyk, authors of the March 2020 study “Do Investors Care about Carbon Risk?” explored whether carbon emissions affect the cross-section of U.S. stock returns. Their data sample covers about 1,000 listed companies since fiscal year 2005, and over 2,900 listed companies in the U.S. since fiscal year 2016. Returns span the relatively brief period 2005 to 2017, a period of increasing attention from ESG-conscious investors. Firm-level carbon emissions data were assembled by seven main providers: CDP, Trucost, MSCI, Sustainalytics, Thomson Reuters, Bloomberg and ISS.
The authors began by explaining that carbon emissions from a company’s operations and economic activity are typically grouped into three different categories: direct emissions from production (scope 1); indirect emissions from consumption of purchased electricity, heat or steam (scope 2); and other indirect emissions from the production of purchased materials, product use, waste disposal, outsourced activities, etc. (scope 3). Following is a summary of their findings:
- Power, electric and multi-utility industries produce the most scope 1 emissions, while consumer finance, thrifts and mortgages, and capital markets are the cleanest. Metals and mining, electric utilities, and construction materials are the three most scope 2 emission-intensive industries (the cleanest industries mimic those based on scope 1 classification). Food products, metals and mining, and construction materials are the three most scope 3 emission-intensive industries. Internet software and services, health care technologies, and software are the three least-intensive industries.
- Stocks of firms with higher total CO2 emissions (and changes in emissions) earn higher returns after controlling for the common factors of size, book-to-market and momentum, and other factors (such as low beta and liquidity) and anomalies (such as idiosyncratic volatility and net stock issuance) that predict returns.
- There is also a significant carbon premium associated with the year-to-year growth in emissions – companies that succeed in reducing their emissions can afford to offer lower stock returns, but companies that keep on burning more and more fossil fuel must resign themselves to offering higher returns.
- The carbon premium is economically significant: A one-standard-deviation (SD) increase in the level and change of scope 1 emissions leads to a 1.8% and 3.1% increase, respectively, in annualized stock returns. A one SD increase in the level and change of scope 2 emissions leads to a 2.9% and 2.2% increase in annualized returns. And a one SD increase in the level and change of scope 3 emissions increases stock returns 4.0% and 3.8% on an annualized basis.
- The carbon premium cannot be explained through differences in unexpected profitability or other known risk factors.
- Institutional investors implement exclusionary screening based on direct emission intensity in a few salient industries – divestment is only based on scope 1 emission intensity, and there is no significant effect of the level of emissions on institutional investor portfolios. Nor are institutional investors underweight scope 2 and scope 3 emission-intensive firms. This is true both in aggregate and for each institutional investor category. Essentially, institutional investors have been applying exclusionary screens (or not) solely on the basis of scope 1 emission intensity.
- The results were robust to numerous tests.
Their findings led Bolton and Kacperczyk to conclude: “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.”
Summarizing, Bolton and Kacperczyk’s findings of a carbon risk premium are consistent with economic theory (risk and expected return being related) and efficient markets. They are also consistent with those of Rocco Ciciretti, Ambrogio Dalò and Lammertjan Dam, authors of the December 2019 study “The Contributions of Betas versus Characteristics to the ESG Premium.” They found that firms with lower ESG scores exhibit higher expected returns. In other words, the research demonstrates that investors recognize increased risk, and demand a premium for accepting it. Companies pay a price in the form of a higher cost of capital. Finally, investors who express their social views in their investments should consider that they are sacrificing an expected return as well as reducing diversification. That, of course, may be a price they are willing to pay to express their social views.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.