Don’t Count on ESG Outperformance

New research shows that the significant outperformance of environmental, sustainable and governance- (ESG-) driven investing over the last decade was due to a sharp increase in concern among investors for climate-related issues. Whether that outperformance continues will depend on even more heightened concerns over the environment.

According to the 2020 Report on U.S. Sustainable and Impact Investing Trends, environmental, social and governance (ESG) investing now accounts for more than one-third of total assets under management in the U.S., about $17 trillion, a 42% increase since 20181. The trend seems poised to continue. Fund sponsors and investors alike often cite improved returns as a top motivation for applying ESG criteria. Adding fuel to that belief, Doron Avramov, Abraham Lioui, Yang Liu and Andrea Tarelli, authors of the October 2021 study, “Dynamic ESG Equilibrium,” found that over the period 2018-2020 a green portfolio outperformed a brown portfolio by about 7% a year. They also found that the excess returns were due to the impact of unanticipated ESG demand shocks on realized returns – a shift in the equilibrium.

Lubos Pastor, Robert Stambaugh and Lucian Taylor contribute to the literature with their September 2021 paper, “Dissecting Green Returns,” in which they addressed this question: What does the past performance of green assets imply about their future performance? In their December 2019 paper, “Sustainable Investing in Equilibrium,” they analyzed the effects of sustainable investing through the lens of a general equilibrium model that “illuminates the key channels through which agents’ preferences for sustainability can move asset prices, tilt portfolio holdings, determine the size of the ESG investment industry, and cause real impact on society.” They used that model to answer the question. Their hypothesis was: “Green assets have lower expected returns than brown, due to investors’ tastes for green assets, yet green assets can have higher realized returns while agents’ tastes shift unexpectedly in the green direction.” They explained: “Green tastes can shift in two ways. First, investors’ preference for green assets can increase, directly driving up green asset prices. Second, consumers’ demands for green products can strengthen – for example, due to environmental regulations – driving up green firms’ profits and thus their stock prices. Similarly, investors’ preference for brown assets or consumers’ demand for brown products can decrease, again making green stocks outperform.”

Their analysis focused primarily on the U.S. stock market. Using environmental ratings from MSCI, a leading provider of ESG ratings, they assigned greenness measures to individual stocks. Their data sample began in November 2012, when MSCI’s data coverage increased sharply, and ended in December 2020. They measured concerns about climate change by using the Media Climate Change Concerns index (MCCC) developed by the authors of the 2021 study “Climate Change Concerns and the Performance of Green Versus Brown Stocks.” This index, which was available from January 2003 through June 2018, is constructed by using data from eight major U.S. newspapers. It captures the number of climate news stories each day as well as their negativity and focus on risk. In addition, they also examined the impact of investor cash flows. As a test of robustness, in addition to analyzing U.S. stocks, they also looked at the performance of German green bonds, the issuance of which began in 2020. Following is a summary of their findings: