Do Investors Care About Carbon Risk?

Patrick Bolton is Barbara and David Zalaznick Professor of Business at Columbia Business School, and Marcin T. Kacperczyk is Professor of Finance at Imperial College London. This post is based on their recent paper. Related research from the Program on Corporate Governance includes Socially Responsible Firms by Alan Ferrell, Hao Liang, and Luc Renneboog (discussed on the Forum here), and Social Responsibility Resolutions by Scott Hirst (discussed on the Forum here).

Almost no day passes without a major news story related to climate change. This week alone Thomson Reuters reported a study that found that the Canadian permafrost is thawing 70 years earlier than forecast. Another Thomson Reuters story the same week announced that Norway’s sovereign wealth fund was to divest its $1 billion stake in Glencore as a result of tighter legislation on responsible investment adopted by Norway’s parliament. And, yet another story in Pensions & Investment magazine reported on a meeting at the Vatican of top executives of energy companies promising to provide investors better information on how they are tackling climate change.

At the same time, considerable skepticism on the importance of climate change, or more generally, environmental, social, and governance (ESG) factors for investors remains. As Eccles and Klimenko (2019) point out in their recent Harvard Business Review article, The Investor Revolution: “The impression among business leaders is that ESG just hasn’t gone mainstream in the investment community.” This raises the question whether carbon risk is currently reflected in asset prices. Our paper is a first exploration into this question. We undertake a standard cross-sectional analysis, asking whether a carbon risk factor or carbon-emission characteristics affect cross-sectional U.S. stock returns.

If ESG hasn’t gone mainstream one would expect to see no significant correlation between stock returns and CO2 emissions, once one controls for all other known risk factors and characteristics. Yet, we find that carbon emissions do affect stock returns. The current reporting standards of carbon emissions distinguish between three different types of carbon emissions: 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). The data on scope 1 & 2 have until recently been more systematically reported. Although scope 3 emissions are the most important component of companies’ emissions in a number of industries (e.g., automobile manufacturing) they are the hardest to measure and have only recently been systematically assembled.

We find that for both scope 1 & 2 and scope 3 emissions there is a positive and statistically significant effect on firms’ stock returns. The effect is also economically significant: a one-standard-deviation increase in scope 3 emission intensity increases stock returns by 11-bps per month, or 1.3% on an annual basis. Similarly, a one-standard-deviation increase in scope 1 & 2 emission intensity leads to a 15-bps increase in stock returns, or 1.8% annualized. Moreover, carbon emissions are associated with higher returns, after controlling for size, book-to-market, momentum, and other well-recognized variables that predict returns. However, when we add industry fixed effects the effect of scope 1 & 2 emissions on firm-level returns disappears. In contrast, the effect of scope 3 emissions on firm-level returns is even stronger once we add industry fixed effects. These results suggest that investors perceive scope 1 & 2 emissions to be common to industries rather than specific to individual firms.

We also explore how much institutional investors are exposed to carbon risk. A first finding is that, in aggregate, institutional investors hold a smaller fraction of companies with high scope 1 & 2 emissions. When we disaggregate by investor categories (mutual funds, insurance companies, banks, pension funds, and hedge funds) we find that insurance companies, pension and investment advisors are also underweight scope 1 & 2 carbon emissions. The negative ownership effect of moving from low carbon emission to high carbon emission is economically large and accounts for about 15-20% of the cross-sectional variation in the ownership variable. This finding is in line with the rise in the sustainable investment movement and the popular negative exclusionary screening investment strategy followed by funds with an ESG tilt. A more surprising finding, however, is that institutional investors are not underweight scope 3 emissions. This is true in aggregate and when we break down institutional investors by categories. It is as if institutional investors have been applying exclusionary screens (or not) solely on the basis of scope 1 & 2 emissions and have not paid attention to scope 3 emissions. This may be due to the fact that reliable firm-level scope 3 emissions data have become available only recently.

Investors seem to have some fuzzy awareness of the cross-sectional differences in scope 3 exposures, but they are clearly constrained by limited information. This is evidenced by our finding of a jump in the scope 3 premium after 2015, when firm-level scope 3 emissions data became much more widely available. In contrast, we find no such jump in the scope 1 & 2 premium after 2015. The main implication of these findings for firms is that they can increase value by reducing their exposure to scope 3 emissions, other things equal. By reducing their firms’ risk exposure to scope 3 emissions they may benefit by lowering their cost of capital. They may also be able to increase value by reducing their scope 1 & 2 emissions, but based on our findings, we cannot exclude the possibility that an individual firm effort may go unnoticed by investors if most of the price effects are driven by industry-level filters. It is possible that striving to be “best in class” in a sector with respect to scope 1 & 2 emissions may not make much of a difference.

The complete paper is available here.

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