Equities | ESG & Climate Change
Scientific consensus has long been reached on a link between human activities and climate change. But now investors have taken notice, and in that light they are actively reassessing their portfolios. For example, institutional investors have committed to divesting $11 trillion in assets of fossil fuel companies. This begs the question: how is carbon risk priced by markets? Academics from the University of Augsburg and Queen’s University, Ontario, have tackled this question in their recent paper, “Carbon Risk”.
They conclude that carbon risk is now influencing equity market performance. But their most notable finding is that firms that become greener see equity outperformance. And importantly, carbon risk can now be considered an additional factor for equity investors along with factors like size, value, and momentum.
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Scientific consensus has long been reached on a link between human activities and climate change. But now investors have taken notice, and in that light they are actively reassessing their portfolios. For example, institutional investors have committed to divesting $11 trillion in assets of fossil fuel companies. This begs the question: how is carbon risk priced by markets? Academics from the University of Augsburg and Queen’s University, Ontario, have tackled this question in their recent paper, “Carbon Risk”.
They conclude that carbon risk is now influencing equity market performance. But their most notable finding is that firms that become greener see equity outperformance. And importantly, carbon risk can now be considered an additional factor for equity investors along with factors like size, value, and momentum.
The Data
The academics start with a global database of over 25,000 companies for the period 2010 to 2017. They whittle this number down to 1,657 for the purpose of testing on the basis of the available data on their carbon risk.
They use four Environmental, Social, and Governance (ESG) databases to collect data on carbon risk:
• The Carbon Disclosure Project (CDP) Climate Change questionnaire dataset.
• The MSCI ESG Stats and the IVA ratings.
• The Sustainalytics ESG Ratings data and carbon emissions datasets.
• The Thomson Reuters ESG dataset.
These databases provide 735 ESG variables that the researchers narrow down to ten that are most relevant for financial markets. They then create three subscores:
• Value chain – captures current emissions related to the production of goods and services.
• Public perception – how the public views the particular firm with respect to carbon emissions.
• Adaptability – the firm’s ability change with respect to carbon and transition-related issues.
An example of an ESG variable to capture the “value chain” would be the Emission Intensity from the CDP database, which measures metric tonnes of CO2 divided by net sales. For “public perception”, an example variable is the Performance Band (CDP), which scores the firm’s progress towards environmental stewardship. For “adaptability”, an example variable would be the Environmental Innovation Score from the Thomson Reuters database. This measures the firm’s capacity to reduce the environmental costs and burdens for customers.
The Brown-Green Score (BGS)
Armed with this data, the researchers create a Brown-Green Score (BGS) for each company. This measures a company’s carbon risk. They create the score by converting each of the ten ESG variables into binary values. So, anything below the median would be a zero and anything above would a one. They then average these binary values to arrive at the three subscores, as described above. For the final BGS score, they give a 70% weight to the Value Chain score, 15% to the Public Perception score, and 15% to the Adaptability Score. The weighted average is then the BGS score for each company. The higher the score, the higher the carbon risk.
Impact on Market Returns
Theory would suggest that “brown” companies would initially experience lower equity prices, which should allow higher future returns to compensate for their higher carbon risk. At the same time, unexpected improvements in the “greenness” of companies would also be rewarded with higher equity returns. These two forces could then be offsetting, which makes it difficult to describe the exact impact of carbon risk on market returns.
A simple way to capture these forces would be to run regressions of the level of BGS score, which capture the first effect – this would proxy investors’ expected carbon risk of a company. Meanwhile, changes in the BGS would proxy unexpected shifts in a company’s “greenness”. The researchers run regressions using levels and changes in BGS along with other common factors believed to explain equity performance such as valuations, size, and investment.
They find that both effects are statistically significant and offsetting. The significance of BGS levels means that brown companies outperform green firms. But the significance of changes means that firms becoming greener outperform those that do not.
They also find that green firms are becoming greener than brown firms are becoming greener (16% annually vs 2%). This suggests the changes effect has dominated the levels effect over their testing period (2010 to 2017).
Carbon Risk in Factor Investing
This is also reflected in the returns of long-short portfolios based on the BGS score. So if one goes long brown companies and short green companies, then the returns are negative with a Sharpe ratio of -0.2. This is likely due to green firms becoming greener much faster than brown firms.
Such a long-short portfolio could be viewed as an equity factor in much the same ways as size, momentum, or valuation are. Long-short portfolios based on those factors have delivered Sharpe ratios of +0.2, +0.7, and -0.1, respectively. The carbon factor then has not dissimilar returns and, importantly, not correlated with these other factors. The authors, therefore, suggests that carbon risk as proxied by the BGS score could be considered a new equity factor.
As for whether carbon risk reflects a risk premium, their battery of tests found it was not currently the case. This could be due to investors’ ability to hedge this risk through non-market means. Or perhaps more likely, that investors do not know how to measure or fully understand this risk.
Bottom Line
This is an important piece of work. It is perhaps of the first that comprehensively assesses the link between carbon risk and market returns. The researchers provide a framework on how to consider such risk in equity portfolios and also how it eventually be viewed as a risk premium. That said, for carbon risk to be considered a proper investment factor a more robust out-of-sample backtesting would need to be done.
Bilal Hafeez is the CEO and Editor of Macro Hive. He spent over twenty years doing research at big banks – JPMorgan, Deutsche Bank, and Nomura, where he had various “Global Head” roles and did FX, rates and cross-markets research.
(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)