In our book, Your Essential Guide to Sustainable Investing, Sam Adams and I explained that economic theory suggests that if a large enough proportion of investors choose to favour companies with high sustainability ratings and avoid those with low sustainability ratings (sin businesses), the favoured company’s share prices will be elevated and the sin stock shares will be depressed. In equilibrium, the screening out of certain assets based on investors’ tastes should lead to a return premium on the screened assets.
The result is that the favoured companies will have a lower cost of capital because they will trade at a higher P/E ratio. The flip side of a lower cost of capital is a lower expected return to the providers of that capital (shareholders). And the sin companies will have a higher cost of capital because they will trade at a lower P/E ratio, the flip side of which is a higher expected return to the providers of that capital.
The hypothesis is that the higher expected returns (a premium above the market’s required return) are required as compensation for the emotional cost of exposure to offensive companies. On the other hand, investors in companies with higher sustainability ratings are willing to accept the lower returns as the cost of expressing their values.
There is also a risk-based hypothesis for the sin premium. It is logical to hypothesise that companies neglecting to manage their ESG exposures could be subject to greater risk (that is, a wider range of potential outcomes) than their more ESG-focused counterparts. The argument is that companies with high sustainability scores have better risk management and better compliance standards. The stronger controls lead to fewer extreme events such as environmental disasters, fraud, corruption and litigation (and their negative consequences). The result is a reduction in tail risk in high-scoring firms relative to the lowest-scoring firms. The greater tail risk creates the sin premium.
Your Essential Guide to Sustainable Investing also presented the empirical evidence that is consistent with economic theory: While ESG investors can express their values through their investments, they should expect lower returns from their portfolios — though they also will be taking less investment risk.
The cost of being green and firm performance
A question that had not been addressed in the literature is what the effect is of green costs on firm performance. The authors of the study I will be reviewing explained: “On the one hand, increasing environmental related costs brings extra burdens on the firm. Going beyond what is required by environmental regulations may be considered as less optimal than maximizing shareholder’s wealth. On the other hand, allocating more resources to deal with environmental issues can reduce environmental related losses such as fines/penalties. Consequently, the net effect of increasing environmental related costs on firm value and risks is not clear.”
Employing environmental performance scores and rankings of S&P 500 firms, Yifan Liu and Leyuan You, the authors of Does the Market Reward Firms for Being More Green or Less Brown? published in the September 2023 issue of the Journal of Economics and Finance, examined these issues and analyzed whether the market rewards firms for superior green performance or for being less brown.
Their data sample was based on the environmental ranking and score data from 2009 to 2016 obtained from Newsweek. The authors noted: “Newsweek ranks the S&P 500 firms according to each company’s actual resource use and emissions, its policies and strategies, and its reputation among its peers. They provide an overall environmental score for each firm based initially on three factors: the environmental impact score, the environmental policy, and the reputation score. The environmental impact score is compiled by Trucost and consists of over 700 variables. The green policy is derived from KLD [now MSCI] data and assesses the firm’s environmental policy and performance. The reputation score is obtained from the Corporate Register survey of professionals, academics, and other environmental professionals. All the scores are normalized so that they range between 0 and 100. Because more firms began to disclose greenhouse gases, energy, water or waste metrics, Newsweek started to use the above metrics in 2014.”
To examine whether the market rewards firms for being more green or less brown, Liu and You compared the one-year excess returns (using the Carhart four-factor model as the benchmark) of green firms (top 50 firms/top decile) and brown firms (bottom 50 firms/bottom decile) to environmentally neutral firms. Following is a summary of their key findings:
- The green firms in deciles 1-4 showed basically no excess return, firms in deciles 5-9 showed excess returns, and firms in decile 10 showed negative excess returns (the brownest firms performed the worst).
- The market rewarded brown firms for significantly improving their environmental performance but did not punish green firms for slipping environmental ranking.
- Brown firms had greater extreme losses due to elevated environmental risks. Compared to being environmentally neutral or green, being brown increased the average daily extreme loss for a two-standard-deviation event by 14%, from $4.00 to $4.60 for a $100 investment. Being brown also increased the average daily extreme loss at three standard deviations by 28.4%, from $7.34 to $9.42 for a $100 investment.
- Increasing environmental-related investments was associated with reduced risk, and increased firm value for brown firms but decreased firm value for green firms. Employing R&D expenses as a proxy for green costs, a 1% increase in the R&D-to-sales ratio was associated with a 0.05% decrease in daily extreme losses and a 0.05% increase in Tobin’s Q (the market value of a company divided by its assets’ replacement cost) for brown firms relative to other firms. However, similar efforts by green firms led to a 0.1% decrease in Tobin’s Q for green firms relative to non-green firms – exposure to environmental risks led to elevated extreme losses, but being green did not reduce environmental performance significantly compared to environmentally neutral firms.
Their findings led Liu and You to conclude: “These results indicate that investors are concerned with the environmental risks associated with being brown. They reward brown firms for significantly improving their environmental performance as committing more resources in green practices effectively reduces extreme losses for brown firms. Recognizing the heavy costs associated with being green, the market does not reward firms for excellent environmental performance and punishes green firms for increasing green costs.” They added: “These findings indicate that the market is concerned with firms’ environmental performance as it recognizes the potential risks associated with being brown and reward brown firms when they improve their environmental performance. Wary of the heavy costs associated with being green, the market does not reward already green firms for increasing green efforts.”
Investor takeaways
The popularity of the ESG movement was driven not only by many investors who were motivated for non-financial reasons to tilt their portfolios toward firms with strong ESG criteria, but also by firms promoting the idea that incorporating ESG factors into portfolios would lead to superior returns (ignoring economic theory). The fact that the empirical evidence did not support the idea that ESG investing would lead to higher returns is probably behind the fading of investor interest. While the U.S. had 656 sustainable funds as of June 30, according to Morningstar data, the number of liquidations has been increasing from prior years.
State Street Corp., Columbia Threadneedle Investments, Janus Henderson Group Plc and Hartford Funds Management Group Inc., among others, unwound more than two dozen ESG funds so far this year. In fact, more U.S. sustainable funds closed in 2023 than the prior three years combined, and investors pulled more money from the funds in the first half of the year than they put into them.
The huge inflows that accompanied the surge in interest in sustainable investing over the years leading up to 2023 led to firms with high sustainable investing scores earning rising portfolio weights, resulting in short-term capital gains for their stocks – realized returns rose temporarily. The result was an increase in green asset returns even though brown assets earned higher expected returns. However, the long-term effect was that those higher valuations of green stocks reduced their expected long-term returns. If the cash flows are now reversing, it could lead to lowered valuations for green firms, negatively impacting performance.
LARRY SWEDROE is head of financial and economic research for Buckingham Wealth Partners, collectively Buckingham Strategic Wealth, LLC and Buckingham Strategic Partners, LLC.
This article is for informational and educational purposes only and should not be construed as specific investment, accounting, legal, or tax advice. Neither the Securities and Exchange Commission (SEC) nor any other federal or state agency have approved, determined the accuracy, or confirmed adequacy of this article. Certain information may be based on third party data and may become outdated or otherwise superseded without notice. Third party information is deemed to be reliable, but its accuracy and completeness cannot be guaranteed. By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party websites. Buckingham is not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them. LSR-23-565
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