By LARRY SWEDROE
As Sam Adams and I demonstrate in our book Your Essential Guide to Sustainable Investing, researchers have found that much of the variation in performance between green and brown (or sin) stocks can be explained by exposures to common factors used in asset pricing models (for example, see here, here and here). In addition, the research (for example, see here and here) also shows that there are conflicting forces at work that can create problems in interpreting research findings, as investor preferences lead to different short- and long-term impacts on asset prices and returns. Firms with high sustainability scores earn rising portfolio weights, leading to short-term capital gains for their stocks — realised returns rise temporarily. However, the long-term effect is that higher valuations reduce expected long-term returns. The result can be an increase in green asset returns even though brown assets earn higher expected returns; in other words, there can be an ambiguous relationship between carbon risk and returns in the short term as the market moves to a new equilibrium.
Joshua Kazdin, Katharina Schwaiger, Viktoria-Sophie Wendt and Andrew Ang contribute to the sustainable investing literature with their study Climate Alpha with Predictors Also Improving Company Efficiency, published in the Winter 2021 issue of The Journal of Impact and ESG Investing, in which they examined characteristics of companies associated with climate change and whether they predict excess equity returns. They used two signals — carbon emission intensities (defined as Scope 1 and 2 emissions divided by sales) and Leadership in Energy and Environmental Design (LEED) building certifications — to determine if they are contemporaneously linked to measures of profitability or productivity.
They constructed standard characteristics that have been shown to predict returns: “the company’s book-to-market ratio (BM); momentum (MOM), defined as the average of the most recent 12 months’ equity returns; idiosyncratic volatility (VOLAT), which is defined as the standard deviation of returns based on past 12 months of monthly returns; and the equity beta (BETA), which is the global market beta from the MSCI Barra Global Equity Model (GEM3) calculated over a one-year period using daily data. Finally, we take variables measuring various aspects of company quality: the implied cost of capital (COC), which we compute with forecasted earnings using earnings estimates for two years and one-year ahead, scaled by current price levels (Easton 2004); gross profitability (GROSSPROFIT), defined as sales less costs of goods sold scaled by total assets; return on assets (ROA), defined as net income scaled by total assets; and Tobin’s Q (TOBIN), defined as the sum of market value of equity and book value of assets less book value of equity scaled by total assets.” Their data sample covered the period 2010-2020 at the monthly frequency.
In terms of LEED certifications, they divided the companies in the MSCI US All Cap universe that have at least one LEED-registered building into three groups based on the number of their certified buildings divided by their previous year’s property, plant and equipment (PPE) expenditures. They then constructed a long-short portfolio, buying the companies with the most LEED certifications (in the top 30 percent) and selling those with the least (bottom 30 percent) relative to their PPE. The LEED data sample covered the period 2013-2020.
Following is a summary of their findings:
- Companies with low carbon emissions tend to have high measures of company performance in terms of implied cost of capital, gross profitability and Tobin’s Q — the outperformance of companies with low carbon emission intensities is consistent with those companies being more efficient. Specifically, the relationship between carbon emission intensity and gross profitability was negative and statistically significant, indicating that an increase in emission intensity by one metric ton per million dollars in sales increases gross profitability by 0.3 percent and implying that lower carbon intensities may reflect greater company efficiencies. Thus, such companies tend to have exposure to the quality (and profitability) factor.
- LEED certifications are correlated with efficiencies in company fundamentals, such as ROA. Lower energy costs may directly reduce company expenses. Another indirect channel is that the focus of a company on its real estate infrastructure reflects attention to obtaining efficiency in other aspects of its supply chain and operations. The annual alpha for a value-weighted long-short portfolio was 1.1 percent, and the correlation of excess returns between the LEED portfolio and the generic quality portfolio was only 16.0 percent, and it was additive to the quality portfolio that uses only financial data.
- Accounting for sector exposures and other characteristics, companies with low carbon emissions exhibit excess returns. A long (top 30 percent)/short (bottom 30 percent) portfolio that goes long companies with low carbon emission intensities and short companies with high carbon emission intensities exhibits an alpha of 1.5 percent per year and is additive to a quality factor that uses only financial data.
- The highest emissions were correlated with relatively poor productivity — consistent with the highest emission intensity companies having relatively inefficient supply chains or production processes. Importantly, the outperformance of the least emission intensive companies was most pronounced within the high-impact group — tilting toward low emission intensity companies, particularly among the companies with the highest emission intensities, can result in return improvements and simultaneously make large reductions in carbon emissions.
- Portfolios constructed with carbon emission intensity and LEED-certified building signals are not highly correlated with a traditional quality factor—exposure to the quality factor doesn’t fully explain the excess returns (this finding is different from that of the authors of the study Honey I Shrunk the ESG Alpha, who found that there is no solid evidence supporting recent claims that ESG strategies generate outperformance when accounting for sector and factor exposures, downside risk and attention shifts.
Kazdin, Schwaiger, Wendt and Ang emphasised that their findings are not statements of direct causality; rather, the predictive patterns in returns of these climate-change-themed measures are consistent with these companies being more efficient on average. Their findings led them to conclude that while climate change risk is systemic, it is not fully reflected in financial markets. They added: “Our positive predictability results are consistent with carbon emissions reflecting company productivity enhancements—that is, a cash flow effect versus a priced discount effect. Because the finance literature has tended to focus on carbon emission variables, our work on LEED predictors appears to be new to the literature.” And finally, they noted that “there should be opportunities to generate excess returns with strategies using climate-related data and signals.”
For investors seeking both climate-related outcomes, such as lower carbon emissions or more environmentally friendly infrastructure being used by companies, and return-based outcomes, such as higher excess returns, the carbon emission and LEED variables present interesting options to meet the dual goals of sustainable investors as they increase exposure to profitability at the same time they reduce environmental impact.
With that said, a word of caution is warranted because it is certainly possible that the publication of their findings could eliminate the anomaly as investors exploit the mispricing — as has been the case with other anomaly discoveries, such as the accrual anomaly (companies with high accruals earned lower returns).
Another note of caution is also warranted because the authors did not examine the impact that the shift in investor preferences for climate-friendly investments has on valuations. As noted, the preference shift has led to a change in the ESG equilibrium and conflicts between short-term outcomes and long-term expected returns. In other words, how much of the alphas they found were due to rising relative valuations of green stocks caused by cash flows induced by the shift in preferences?
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LARRY SWEDROE is Chief Research Officer at Buckingham Strategic Wealth and the author of numerous books on investing.
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