Does ESG Investing Force Dirty Companies to Change?
- By Sam van de Schootbrugge
- 6 min read
Summary
- A Journal of Banking and Finance paper examines whether mutual fund decarbonisation affects the stock prices of divested firms and helps reduce these firms’ carbon emissions.
- Consistent with theory, greater decarbonisation selling pressure decreases stock prices and encourages divested firms to reduce their carbon emissions.
- However, high-emitting firms that escape divestment have increased emissions throughout the sample period, highlighting the importance of a critical mass of investors in influencing behaviour.
Introduction
One of the most debated issues in ESG is whether to divest from certain assets. As of 2021, over 1,300 institutions representing approximately $14.5tn in assets have publicly pledged to divest from the fossil fuel industries. Yet surprisingly, little empirical evidence exists that divestment strategies reduce the carbon emissions of high-polluting firms. That is, until now.
A new Journal of Banking and Finance paper is the first to empirically analyse the impact of portfolio decarbonisation on stock prices and carbon emissions. Portfolio decarbonisation involves divesting from carbon-intensive firms to reduce a portfolio’s carbon intensity. Based on a large sample of US and European equity mutual funds, they find:
- Highly carbon-intensive firms that have experienced decarbonisation selling pressure tend to suffer a cumulative industry-adjusted return of -6.7% over 24 months. This compares with -1.4% for firms that also face selling pressure, but for reasons other than carbon.
- Meanwhile, high-carbon stocks that escape divestment only suffer a small and steady abnormal return of -1.2% over the same period. These non-divested firms also, on average, increase their carbon emissions, while divested firms reduce them.
The Theory of Divestment
In theory, divestment creates collective pressures from investors and stakeholders that encourages high polluters to decrease their carbon emissions. The theory predicts the main impact channel: divestment from carbon-intensive firms increases their cost of capital, subsequently affecting their stock price, and thereby pressuring them to decrease their carbon emissions.
According to George Serafeim, ESG guru at Harvard Business School, this positive outcome is not guaranteed. Divestment can reduce a firm’s valuation below its cashflow-generating capacity, possibly forcing them to go private. Private companies have minimal reporting obligations, reducing transparency. It also transfers wealth from public to private investors and harms their ability to implement change.
Methodology and Data
The authors obtained data on annual stock-level carbon emissions from three major carbon data providers for 2010 to 2017: Refinitiv Datastream, CDP, and Sustainalytics. They calculate stock-level carbon intensity based on how many metric tons of carbon dioxide equivalents are emitted for one dollar of net sales for each firm in each year – a measure on which divestment strategies are generally concentrated. Overall, the authors calculate the carbon intensity of 10,000 companies, representing around $69tn market cap worldwide, or 87.1% of the global stock market.
For mutual funds, the authors get holdings from Morningstar. The holdings dataset includes the quarterly holdings reports of 4,646 actively managed US and European equity funds from 1983 to 2017. This equals 14.3% of the size of the combined US and European stock markets. From these, they calculate:
- Fund-level carbon intensity: This is the weighted average carbon intensity (WACI) in tons per dollar; it measures the fund’s exposure to carbon-intensive companies.
- Mutual funds’ decarbonisation potential: This measures how much a carbon-intensive holding would reduce a fund’s WACI were it divested.
- Actual mutual fund decarbonisation: This quantifies the actual level of decarbonisation intended by mutual funds, split into active and passive QoQ WACI change.
- Stock-level decarbonisation selling pressure (DSP): This is the proportion of decarbonisation and carbonisation trades per quarter for each stock, giving a measure of selling pressure. This is contrasted with the selling pressure of stocks not in the decarbonisation or carbonisation category.
Stylised Facts
Firstly, the authors find mutual funds could significantly decarbonise portfolios by divesting from only a handful of the dirtiest holdings. This makes sense: most carbon emissions globally are concentrated in a few highly emitting firms. On average, the five dirtiest holdings account for more than half of a funds’ WACI but represent only 7.8% of the portfolio weight (Chart 1).
Next, they find mutual funds with high exposure to carbon-intensive companies are more likely to decarbonise. However, US-domiciled funds are less likely to heavily decarbonise their portfolios compared with European funds. Also, large-cap value, small-cap blend, and mid-cap blend funds (base case) are less likely to heavily decarbonise than the other styles. Small and large growth fund styles are most likely to decarbonise.
The Effects of Decarbonisation on Stock Prices
The authors calculate monthly industry-adjusted abnormal stock returns using the equal-weighted French-48-industry-portfolios. They analyse the impact of facing high (in the top decile) selling pressure from mutual funds on a stock’s price.
Overall, stock prices decline when selling pressure from mutual funds is high. High emitters (HDSP) face the largest price declines, with a cumulative industry-adjusted return of -6.7% over two years. Stocks that were divested for reasons other than carbon (HGSP) fell -3.4% over the same period (Chart 2). Stocks that faced no selling pressure (NSP) were broadly unchanged (Chart 2).
There are two key conclusions. First, mutual fund decisions can significantly affect stock prices. Second, fund decarbonisation herds other investors into divesting in subsequent periods, impacting prices for up to two years after. In contrast, divesting from stocks for non-carbon reasons has an immediate effect on prices, but nothing thereafter.
Next, the authors look only at highly carbon-intensive stocks. Most of these stocks also faced high selling pressure, but not all. Stocks of high emitters that were not divested by mutual funds only declined 1.2% over two years. And so, a key determinant of the price action for highly carbon-intensive firms is whether mutual funds divest.
The Effects of Decarbonisation on Carbon Emissions
Similarly, the authors examine the impact of fund divestment on the carbon emissions of divested companies. There is a clear distinction. Firms that faced high decarbonisation selling pressure decreased their carbon emissions over 48 months. Those that faced selling pressures for reasons other than carbon, and those that faced no selling pressures, increased emissions (Chart 3).
Again, the results hold especially true for high emitters that have been divested. Meanwhile, high emitters that have not been divested by mutual funds tend to increase their carbon emissions after 48 months. The findings are robust across alternative calendar timeframes.
Bottom Line
Mutual fund decarbonisation appears to have positive societal consequences. Communicating divestment decisions crowds in the masses, which ultimately works to reduce carbon emissions. However, returning to Serafeim’s thoughts, divestment may not always be the best way of reducing carbon emissions. Instead, he argues for combining divestment and engagement. In this case, setting minimum standards, transparently communicating those to investees, providing an ambitious but realistic time horizon to meet the standards, and exiting the investment if the investee fails to meet the standards. For the largest emitters, though, I think both Serafeim and the present paper’s authors would agree that a collective divestment approach is the most effective way to reduce emissions.
Sam van de Schootbrugge is a Macro Research Analyst at Macro Hive, currently completing his PhD in international finance. He has a master’s degree in economic research from the University of Cambridge and has worked in research roles for over 3 years in both the public and private sector.