Dissecting Green Returns

Green assets delivered high returns in recent years. This performance reflects unexpectedly strong increases in environmental concerns, not high expected returns. German green bonds outperformed their higher-yielding non-green twins as the "greenium" widened, and U.S. green stocks outperformed brown as climate concerns strengthened. To show the latter, we construct a theoretically motivated green factor---a return spread between environmentally friendly and unfriendly stocks---and find that its positive performance disappears without climate-concern shocks. A theory-driven two-factor model featuring the green factor explains much of the recent underperformance of value stocks. Our evidence also suggests small stocks underreact to climate news.