The Hidden Risks in Climate-Solution Investing
New research shows that portfolios that owned companies that provide climate solutions outperformed ones that owned firms with low carbon intensity. Before you adapt that approach, however, beware that this research relies on a small sample of data over a short time period.
Interest in sustainable investing has boomed in recent decades. Responding to that demand, an increasing number of climate funds and indices have been launched, most of which seek to reduce the carbon footprint of a portfolio by excluding firms with high carbon intensity. Examples are indices such as the MSCI ACWI Low Carbon Target Index and the MSCI ACWI Climate Change Index; and ETFs such as the iShares MSCI ACWI Low Carbon Target ETF (CRBN), with about $1.3 billion of assets; the iShares Global Clean Energy ETF (ICLN), with about $4.7 billion of assets; and the First Trust NASDAQ® Clean Edge® Green Energy ETF (QCLN), with about $2.2 billion of assets (data from Morningstar as of February 2022).
While some indices and funds reduce their climate footprint by comparing firms irrespective of industry membership, others create best-in-class benchmarking, thereby allowing representation of all industries (their greater diversification reduces tracking error risk).
Along with the increased interest by investors has been increased attention by researchers on the impact of sustainable strategies on the risk and returns of a portfolio. Alexander Cheema-Fox, George Serafeim and Hui Wang contribute to the sustainable investing literature with their February 2022 study, “Climate Solutions Investments.” They began by noting that while sustainable funds do lower exposure to climate risk, they do not necessarily provide an investor with exposure to climate opportunities: “The transition to a low carbon economy requires the development, deployment, and scaling of several key new technologies, products, and services. These climate solutions range from renewable energy, electrification of transportation and processes, battery technology, energy and process efficiency, circularity, new agricultural practices, and plant-based protein alternatives to meat. These solutions should see top-line revenue growth as the world proceeds to decarbonize.”
They went on to explain that while “pure-play” portfolios (such as the aforementioned ICLN and QCLN) and indices provide exposure to such climate solutions, such as companies engaged in clean tech, renewable energy and energy storage, there is an absence of a systematic process through which an investor can identify companies whose main focus is on climate solutions. In addition, there is no generally accepted definition of “green” economic activities. The authors noted: “The lack of process for constructing a sample of climate solutions companies inhibits the systematic study of their accounting and stock market performance over time.” To address that issue, they developed a process that allowed them to identify a large set of publicly listed companies that are engaged in developing climate solutions.
Their process relied on “reviewing international reports, regional net zero frameworks, research papers, and relevant news, from which we identify 10 business areas central to climate change solutions: agriculture and food; building and housing; carbon capture, utilization, and storage; energy generation; energy storage; materials; nature-based solutions; recycling and circularity; and transportation. Within each business area, we conduct a thorough investigation to assess the landscape of climate technology and innovation. From this research, we generate a list of 164 relevant keywords and phrases specific to these business areas and identify those in company business descriptions. To keep our sample and analysis as sensitive as possible to exposure to climate opportunities we exclude companies for which only part of their business is related to climate solutions, for example an automobile manufacturer that provides both electric and internal combustion engine vehicles. The drawback of this choice is that our sample underestimates the total number of companies and size of the publicly listed climate solutions market.”
Having identified them, the authors analyzed the accounting fundamentals, valuation ratios and stock performance of 632 global companies (a much larger sample than typically found in indices and funds) over the period January 2011-October 2021. They constructed value- and equal-weighted climate solutions portfolios (CSP). These portfolios were formed at the end of 2010 and rebalanced monthly. Following is a summary of their findings:
- There was dramatic growth in the climate solutions market segment – a 993.5% increase in market capitalization, to almost $2.5 trillion by October 2021.
- Recently, investors have been able to gain exposure in public markets to an increasing number of companies that provide solutions beyond solar and wind power, such as batteries and storage, food, materials and transportation.
- Almost half of companies (and market capitalization) in the sample were in emerging markets, with China representing the biggest country allocation (36%) on both an equal- and market-capitalization-weighted basis. The U.S. had a 31% share, Europe a 15% share and emerging markets ex-China a 10% share.
- Climate solutions companies were less profitable but experienced higher revenue growth than their industry peers – a portfolio of climate solutions companies exposed investors to lower profitability, higher top-line revenue growth, and investment firms focused on developing scale to provide solutions for their customers.
- The CSP exhibited lower earnings yield and book-to-market (they are growth stocks), consistent with the market reflecting the higher anticipated growth prospects and expecting that growth premium to materialize in the future. The one exception is that on an equal-weighted basis, the CSP exhibited higher book-to-market (they are value stocks), a reflection of some smaller climate solutions companies facing financial difficulties.
- The CSP had negative value- and equal-weighted industry-adjusted return on asset (ROA) ratios. However, since late 2019 there has been a positive trend in the value-weighted and industry-adjusted ROA ratios for these portfolios, with larger companies (such as Tesla) starting to reach median industry profitability. In contrast, the equal-weighted portfolio became even less profitable over time.
- CSP companies had higher capital expenditures, higher R&D investments, and greater selling, general and administrative expenses than their industry peers – consistent with the hypothesis that companies that provide decarbonization solutions to the market are transforming industries with new technologies, and that these innovations require significant investment in human, intellectual and physical capital.
- The CSP was highly correlated (0.82-0.85 on a value-weighted basis) with pure-play indices such as S&P Global Clean Energy and NASDAQ Clean Edge Green Energy (~0.5 after stripping out market returns). In addition, it shared with those indices a high tracking error relative to the market index (~15-20%). This contrasts with various decarbonized portfolios, which had much lower tracking error (~1.5%).
- After accounting for market returns, there was close to zero correlation between the returns of the CSP and those of low carbon indices, suggesting that the two products are distinct.
- CSP outperformed the overall market index MSCI ACWI for both value-weighted and equal-weighted portfolios from 2011 to 2021. Using multifactor regressions (the five Fama-French factors of market, value, size, profitability and investment), from 2011 to 2021 the value-weighted portfolio generated a total return of 14.8% annually, an alpha of 10.0% (significant at the 10% level) and a Sharpe ratio of 0.80. The period 2018 to 2021 saw a much higher total return of 40.1% per annum, a higher excess return of 22.9% (significant at the 10% level) and a higher Sharpe ratio of 1.70. The equal-weighted portfolio produced more statistically significant alphas, about 11.9% during 2011 to 2021, and 13.8% after 2018. This compares to the MSCI ACWI return of 10.1%, a risk level of 14.3%, and a Sharpe ratio of 0.71 annually from 2011 to 2021.
- Compared to the MSCI ACWI Low Carbon Target Index and the MSCI ACWI Climate Change Index, the CSP (both equal-weighted and value-weighted) outperformed in risk-adjusted terms.
Their findings led Cheema-Fox, Serafeim and Wang to conclude: “While the low carbon index seeks to reduce the exposure of an investor to high carbon businesses that might be disrupted from regulatory and technological developments, the climate solutions portfolio provides an investor with exposure to innovative and growing businesses that seek to capitalize on the transition to a low carbon economy.” They added: “On an equal-weighted basis, the portfolio provides exposure to companies that invest heavily in innovation and talent but also exposure to higher losses.” They also noted: “It is important to clearly differentiate climate solutions investments from more broadly based, less pure-play investment products that take climate change into account: they provide investors with different exposures. Specifically, the returns of a climate solutions portfolio exhibit zero correlation, after accounting for market returns, with those of indices that lower the carbon emission exposure.”
Before you draw any conclusions from the results, consider the following. First, given the relatively small sample size, the spectacular performance of a single company, or a few companies, can greatly impact the CSP results. As an example, excluding Tesla from the data, the CSP portfolio would have had similar factor exposures, but the value-weighted returns would have been 8.4% instead of 14.8% for the 2011-2021 period, and 22.3% instead of 40.1% for the 2018-2021 period. However, even excluding Tesla, the CSP generated alphas of 6.5% and 13.8%, respectively, which were significant at the 10% confidence level.
Second, the period studied was not only relatively short (one reason for the low t-stats) but was also one that saw a dramatic increase in cash flows to sustainable investment strategies. Those cash flows can create problems in interpreting research findings, as changing investor preferences lead to different short- and long-term impacts on asset prices and returns. Over the period studied, firms with high sustainable investing scores earned rising portfolio weights, leading to short-term capital gains for their stocks – realized returns rose temporarily. This was particularly true over the later period studied (beginning in 2018). However, the long-term effect is that the higher valuations reduce expected long-term returns (recall the dot-com era when valuations were driven to very high levels). 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. With that said, we might be in the “early innings” of the trend toward increasing investor demand for sustainable investment strategies. That could mean that “green” companies will earn even higher valuations.
Cheema-Fox, Serafeim and Wang demonstrated that investing in companies with high environmental (low carbon) scores is different than investing in companies that are focused on providing climate solutions. High-environmental-score strategies can be designed to have very low tracking error to the market, and they can also be designed to target exposure to various factors that have shown premiums (such as value and profitability) – as Dimensional’s sustainable funds do. On the other hand, climate-solutions strategies tend to have exposure to companies with high valuations (growth stocks that reflect high expectations of future earnings) and low current profitability, and they come with significant tracking error risk. Historically, companies with those characteristics have not provided above-market returns over the long term because investors have tended to overestimate their ability to generate profits. In addition, investor preferences can cause valuations to rise, leading to lower future returns. Forewarned is forearmed.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.
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