Investors often cite improved returns as a primary motivation for applying ESG criteria, and investment managers often market sustainable investment products as offering superior returns.
Additionally, over the past decade, environmentally friendly stocks have outperformed those at the opposite end of the environmental spectrum.
Of course, managers should warn clients that past performance does not necessarily predict future returns, and we believe investors should heed this warning when dealing with green assets.
Indeed, the gap between historical returns and what investors should expect is at the heart of our study.
What does the theory say?
Investors should expect green assets to underperform brown assets, not outperform them. As we have shown previously (Pastor, Stambaugh and Taylor, 2021), investors should expect green assets to have lower returns because:
• Many investors are satisfied to feel that they are investing responsibly by allocating more to green assets, while reducing or divesting from their brown holdings. This relatively higher demand means that green assets command higher prices, implying lower expected returns.
• green assets perform better than brown ones in the face of bad weather news. These higher yields thus cushion the blow of this news for holders of green assets. This hedging ability also determines investor preferences, which again results in higher prices and lower expected returns for green assets compared to brown assets.
What does the practice (data) show?
The decline in expected returns from green assets is more than theoretical, as our analysis of the data demonstrates.
We calculate the rate of return which equates the current price of an asset to the discounted stream of its future earnings. For a bond, this rate of return is simply its yield to maturity. For a stock, we use its implicit cost of capital (ICC), because the stock’s expected return is not directly observable.
In either case, this calculated rate of return is the future return on the asset that an investor should expect. We then compare these expected returns for green and brown assets.
For bonds, as of 2020, the German government bond market offered a clear comparison between green and non-green bonds, and the former always had lower yields. For stocks, green stocks consistently had lower ICCs than brown stocks over the previous decade, with their green measured using MSCI environmental scores.
Remove unexpected returns
We also look at what drove the returns achieved, recognizing that what was expected may differ from what actually happened. Green stocks have outperformed over the past decade because their prices have risen unexpectedly relative to brown stocks. The main driver of this outperformance was unfavorable weather news, as measured by Ardia et al. (2021).
During the months when major news outlets carried particularly negative climate news, green equities significantly outperformed brown equities. In fact, if we remove these climate news shocks as well as unanticipated earnings news, we find that green stocks would have underperformed brown stocks.
Figure 1 displays this result. The solid line shows a strongly positive realized performance of a green-minus-brown (GMB) portfolio, which is long green stocks and short brown stocks.
The dotted line shows a slightly negative counterfactual performance of the GMB portfolio, which we believe would have occurred in the absence of the weather and earnings shocks. The figure shows that the realized performance greatly exceeded the counterfactual performance.
The dotted line provides a better estimate of the expected performance of the GMB portfolio in the future than the solid line. The solid line sits well above the 95% confidence interval for the counterfactual performance, indicating that the realized performance of green stocks relative to brown stocks was significantly better than expected.
Figure 1. Actual and counterfactual GMB performance
Why should adverse weather news drive up green stock prices and lead to unexpected outperformance? Heightened climate concerns:
• can increase investors’ desire to hold green assets; and
• are likely to increase expected future profits of green companies and reduce expected profits of brown companies, for example by increasing expected sales of electric vehicles while increasing the likelihood of carbon taxes and regulations.
Value vs Growth
Our study also offers new insight into the contrasting styles of value and growth investing. For nearly a century, value stocks have outperformed growth stocks on average. Over the past decade, however, value stocks have significantly underperformed growth to an extent never seen before.
This historical underperformance of value stocks can largely be attributed to the outperformance of green stocks relative to brown stocks. Once we control for our green factor – the theoretically motivated difference between green and brown stock returns – most of this underperformance disappears. The simple reason is that value stocks tend to be brown on average, while growth stocks tend to be green.
Overall, our findings suggest that investors should not expect to earn superior returns on green assets in the future. Green assets have outperformed in the past, but this has been driven by unexpected shocks that are unlikely to reoccur in the future.
This blog is written by PRI staff members and guest contributors. Our aim is to contribute to the wider debate around topical issues and help showcase some of our research and other work we undertake to support our signatories. Please note that while you can expect to find articles here that broadly reflect the official views of the PRI, the blog authors write in their individual capacities and there is no ‘house view’. The views and opinions expressed on this blog also do not constitute financial or other professional advice. If you have any questions, please contact us at [email protected]
Ardia, David, Keven Bluteau, Kris Boudt and Koen Inghelbrecht, 2021, Climate change concern and the performance of green versus brown stocks, Working paper, National Bank of Belgium.
Pastor, Lubos, Robert F. Stambaugh and Lucian A. Taylor, 2021, Sustainable Investing in Balance, Journal of Financial Economics 142, 550–571.
Pastor, Lubos, Robert F. Stambaugh and Lucian A. Taylor, 2022, Dissecting green return, Journal of Financial Economics, forthcoming.