Investments in companies aligned with environmental, social, and governance (ESG) principles have exploded in the past decade. Sustainable investing now accounts for a third of all professionally managed assets, according to the SIF Foundation, which promotes sustainable investment, and at BlackRock, the world’s biggest asset manager, 88 percent of clients say the environment is the “priority most in focus” among ESG criteria.
Green (environmentally friendly) stocks had quite a decade in the 2010s, dramatically outperforming their brown (environmentally unfriendly) counterparts, according to research by Chicago Booth’s Lubos Pastor and University of Pennsylvania’s Robert F. Stambaugh and Lucian A. Taylor. But green stocks don’t have superior expected returns, the researchers argue. Rather, bad climate news tends to help green assets, whose performance reflects rising concerns about the health of the planet.
Pastor, Stambaugh, and Taylor in 2020 introduced a theoretical model to explain the movement of green stocks. In their model, green stocks have lower expected returns than brown stocks, as investors who want to hold green assets bid up the prices for those stocks. But green assets can still outperform brown ones when investors develop a stronger taste for green stocks, such as when there is bad climate news or discussion of environmental legislation or regulation.
To find out if their model would explain stock movements over the past decade, the researchers looked at US stock performance from November 2012 to December 2020, using ratings of companies’ ESG performance put out by finance company MSCI to differentiate green and brown securities. They applied their model to calculate a “green factor,” the return spread between environmentally friendly and unfriendly stocks. They find that the green factor delivered a significantly positive return over this period.
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What Green Investing Means for Companies, Shareholders, and SocietyThey then factored in US media coverage of climate change. They find that as climate-related news nearly doubled over the past decade, the green factor moved in tandem. Zooming in on individual climate events—California forest fires or a deadly hurricane, for example—revealed a corresponding surge in green-stock performance about a month after the news peaked, the research demonstrates. But in months without climate-concern shocks, the green factor disappeared.
When the researchers took into account capital flows into sustainable funds as a measure of investors’ climate concerns, they find that green stocks might have underperformed brown ones in periods without climate events. The connection between fund flows and the performance of green stocks is hard to estimate, as flows are just one factor of many that can drive stock prices. However, when the researchers zeroed out both climate-concern shocks and flows in and out of sustainable funds, the green factor had a negative return.
The researchers also find that the greener a stock, the higher its average return. But this correlation disappeared between climate-change events, which suggests that bad news caused the superior performance, echoing the main findings: green assets outperformed brown amid climate surprises, despite their otherwise lower expected returns.
Pastor, Stambaugh, and Taylor conclude that higher green returns realized in recent years are likely to be misleading predictors of the future—as green stocks will still underperform brown ones in the absence of unexpectedly bad climate news. At the same time, their empirical analysis reinforces their theoretical finding that greener companies will have lower costs of capital, which is good for their businesses as well as for society.
Lubos Pastor, Robert F. Stambaugh, and Lucian A. Taylor, “Dissecting Green Returns,” Working paper, June 2021.
Lubos Pastor, Lucian A. Taylor, and Robert F. Stambaugh, “Sustainable Investing in Equilibrium,” Journal of Financial Economics, forthcoming.
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