Monetization is the Key to Measuring Corporate Environmental Performance

Nicholas Z. Muller is Lester and Judith Lave Professor of Economics, Engineering, and Public Policy at Carnegie Mellon University Tepper School of Business. This post is based on his recent paper. Related research from the Program on Corporate Governance includes The Illusory Promise of Stakeholder Governance (discussed on the Forum here) and Will Corporations Deliver Value to All Stakeholders?, both by Lucian A. Bebchuk and Roberto Tallarita; For Whom Corporate Leaders Bargain by Lucian A. Bebchuk, Kobi Kastiel, and Roberto Tallarita (discussed on the Forum here); and Restoration: The Role Stakeholder Governance Must Play in Recreating a Fair and Sustainable American Economy—A Reply to Professor Rock by Leo E. Strine, Jr. (discussed on the Forum here).

Investing according to environmental, social, and governance (ESG) criteria has gained considerable momentum, influencing enormous flows of capital. Numerous financial products track aspects of ESG performance. In a recent working paper, I argue that most prior metrics focusing on environmental performance have mismeasured firm conduct in two ways. And the paper demonstrates that the tools and data needed to improve upon current products are available for use.

The first serious flaw is that most indices track physical emissions instead of monetary damage. The emphasis on emissions likely arises because calculating damage is more difficult than simply tabulating tonnage. Advances in modeling now enables connecting emissions to monetary cost. My working paper shows how to estimate damages and how incorporate these external costs into firm value. Second, many major products track only firms’ carbon intensity. This narrow perspective, in part, stems from the focus on emissions. In the U.S. economy, CO2 emissions totaled about 5 billion tons in 2019. In contrast, combined emissions of common air pollutants amounted to under 100 million tons in the same year. So, if an analyst is only considering firms’ total emissions, it would seem that tracking CO2 sufficiently captures firms’ environmental performance.

So, what’s wrong with measuring carbon intensity in tonnage? First, recent research indicates that, globally, damage from fine particulate matter (a type of local air pollution) is between two and three-times greater than the damages from CO2 over the past 20 years. An index only measuring carbon intensity clearly misses important determinants of firms’ environmental conduct. If the goal of ESG investing is to better align capital allocations with actual firm conduct, a carbon-only index falls short.

Second, in most economies around the world, CO2 emissions are unregulated. (The EU is a noted exception.) Because regulations for air pollution are common, a carbon-centric index misses a range of risks stemming from lost profits due to costly compliance measures or from reputational risks associated with publicly announced violations. Extant policy risk manifests primarily for pollutants other than CO2. These risks lie outside the scope of many existing ESG metrics.

Third, monetization of pollution damage facilitates a quantitative rethinking of firm value. In financial markets, the allocation of capital depends, in part, on metrics such as book value, operating free cash flow, or market capitalization. Absent Pigouvian taxes, which would charge firms the monetary damage caused by their emissions, these market-based measures do not reflect external costs or benefits stemming from firms’ production processes or the subsequent use of their products. My working paper contends that financial markets fail to reflect these determinants of firm value and, as a result, inefficiently allocate capital in pollution-intensive industries. A monetary ESG index defined over multiple pollutants will help to mitigate these inefficiencies.

It is well-known that, in order to serve the function of efficiently allocating capital, financial markets require good information regarding firm value and risks. A monetary, multi-pollutant environmental performance index of the sort described above informs markets in two ways. First, the deduction of damages adjusts commonly relied on metrics of firm value according to the costs emissions impose on society. This provides investors with a more socially comprehensive assessment of firms’ worth. Simply tracking tonnage of emissions does not permit a recalibration of firm value. Second, a multipollutant index captures a broad range of risks beyond those associated with carbon. Neither function is possible without monetization. Both enhance the information available to market participants focused on ESG investing.

My working paper focuses on the utility sector in the U.S. economy from 2014 to 2017. The focus lies on the utility sector because of a relatively high degree of pollution intensity, as well as excellent information on plant ownership and pollution emissions. The pollutants covered include primary fine particulate matter (PM2.5), sulfur dioxide (SO2), nitrogen oxides (NOx), ammonia (NH3), volatile organic compounds (VOCs), methane (CH4), nitrous oxide (N2O), and carbon dioxide (CO2). The first five pollutants contribute to local air pollution. The last three are greenhouse gases. The specific methods and data requirements used to calculate damage are discussed at length in the paper. Unlike greenhouse gases, the damages from air pollution depend on the location of emissions. As such, geographically-detailed data and highly-resolved models are necessary to estimate the damage from air pollution. This nuance is not captured by current ESG indices.

The paper proposes a new index calculated as the ratio of each firm’s contribution to total utility sector pollution damage to each firm’s contribution to total utility market capitalization. The index conveys the relative magnitude of how much each firm causes in damage to how much each firm contributes to industry value. The paper tests whether key financial outcomes respond to this measure of environmental performance.

The key empirical results reported in the paper are the following.

  • Firms that became more pollution intensive incurred significant reductions in their share prices. These firms also exhibited higher, but more volatile, returns, as presumably, investors required greater compensation for risk.
  • Financial analysts systematically underestimate the earnings of firms that grew dirtier. This effect is stronger for firms that produce emissions and damages from a relatively small number of plants. I hypothesize that fewer polluting plants lowers the cost of analyst’s assessing firms’ performance.
  • Most financial outcomes are significantly more sensitive to the multi-pollutant index, which combines all eight pollutants, relative to indices focusing on either only carbon or only local air pollution.
  • Subsequent research on the same sample of firms suggests that the relationship between environmental performance and financial outcomes is strongest for firms that are part of the Standard and Poor’s 500. Earlier research suggests this may be due to the greater exposure of such firms to public and shareholder pressure.

These results suggest that the multipollutant index may provide asset managers, investors, and other market participants with new insights, relative to the standard reliance on carbon intensity, regarding the relationship between environmental performance and financial outcomes. Such insights may inform new capital allocation strategies. From the perspective of ESG disclosure requirements, an index based on the multipollutant measure proposed in this paper is more likely to affect capital allocation decisions than disclosure of carbon intensity. If a goal of standardized ESG disclosure is to affect behavior, the new index proposed in my working paper is clearly superior to previous metrics.

The complete paper is available for download here.

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