Will “Green” Stocks Continue to Outperform?
Economic theory says that “green” stocks – those of companies with a low carbon footprint – should underperform “brown” ones. But in recent years that has not been the case, and new research explains how cash flows to sustainable strategies have driven short-term outperformance.
In the face of accelerating climate change, investors are making capital allocations seeking to decarbonize portfolios by reducing the carbon intensity of their holdings. Alexander Cheema-Fox, Bridget Realmuto LaPerla, George Serafeim, David Turkington and Hui (Stacie) Wang contribute to the sustainable-investing literature with their study, “Decarbonization Factors,” published in the fall 2021 issue of The Journal of Impact and ESG Investing. They examined whether institutional flows to decarbonization strategies affect returns as investors incorporate information about climate change into their investment processes.
Their data sample spanned the period June 30, 2009-December 31, 2018, for the United States and Europe. They constructed decarbonization factors that were industry neutral and went long low-carbon-intensity and short high-carbon-intensity sectors, industries or companies with a market cap of at least $2 billion. They classified sectors, industries or companies into high or low carbon emissions by the sum of scope 1 and scope 2 carbon emissions over sales. This metric is known as carbon intensity and reflects how carbon efficiently one dollar of revenue is generated. They considered six portfolio formation strategies including rotations across industries and sectors and across companies (best in class). Portfolios were re-formed annually.
Following is a summary of their findings:
- Different strategies produce carbon emissions that vary greatly.
- Strategies that lowered carbon emissions more aggressively performed better (an alpha of about 2%, especially in Europe) – after controlling for traditional factors (market, size, value, momentum, investment and profitability) and the oil return (the return from crude oil on the futures market). Decarbonization factors that achieve greater carbon reduction also deliver greater alphas.
- Decarbonization factor returns are associated with contemporaneous institutional flows into the factors – buying decarbonization factors when coincident flows are positive while selling when they are negative yields significant alphas – between 1.5% and 4.4% in the United States and 2.5% and 8.5% in Europe over the sample period.
- Combining decarbonization factors without accounting for flows hardly improved portfolio performance in almost all cases.