A working paper out of the National Bureau of Economic Research finds that companies with higher emissions actually earn higher returns when containing for external factors. The paper’s findings fly in the face of the divestment campaign and its simplistic view of eliminating certain sectors over others from a portfolio based solely on narrow ESG factors.
The paper looked at a cross-section of U.S. stock market returns and compared emissions levels by three separate measures: “1) the total level of emissions; 2) the year-by-year change in emissions; and, 3) emission intensity, which measures carbon emissions per unit of sales.”
“The lack of consensus among institutional investors around climate change naturally raises the possibility that carbon risk may not yet be reflected in asset prices. To find out, this paper systematically explores whether investors demand a carbon risk premium by looking at how stock returns vary with CO2 emissions across firms and industries. We undertake a standard cross-sectional analysis, asking whether carbon emissions affect cross-sectional U.S. stock returns.”
And what did the economists find?
“Our main finding is that stocks of companies with high levels and growth rates of emissions have higher returns than those of companies with low levels and growth rates of emissions for all three emission categories. This result contradicts the carbon alpha hypothesis that portfolios short high carbon emission stocks and long low carbon emission stocks generate abnormal returns.”
This implies that fossil fuels are still an integral piece of the overall economy and growth is still correlated to their use. Divestment does not account for the fact that these companies are still critical to consumers.
While ESG investing is becoming more widely adopted on the institutional investor level, and pensions and insurance companies face increased pressure to divest, this paper finds that such investment mechanisms and screenings are only skin deep and do not adequately address a company’s actual emissions.
“Remarkably we find that divestment is only based on scope 1 emission intensity, and that there is no significant effect of the level of emissions on institutional investor portfolios. Nor are institutional investors underweight scope 2 and scope 3 emission-intensive firms. This is true both in aggregate and for each institutional investor category.”
So those carrying out some sort of divestment have not placed consideration on intensity or growth of emissions, and have a very limited view on what a “low carbon” investment entails.
“Essentially, institutional investors have been applying exclusionary screens (or not) solely on the basis of scope 1 emission intensity. Even more remarkable, we find that when we exclude the industries with the highest CO2 emissions (oil & gas, utilities, and motor industries) then there is no significant exclusionary screening at all by institutional investors, whether based on emission levels or emission intensity. In other words, the exclusionary screening is done entirely in these salient industries, and in all other industries there is no significant divestment… Although there is significant divestment by institutional investors it has no significant effect on stock returns. Institutional investor portfolios are significantly underweight firms with high scope 1 emission intensity, but stock returns are not affected significantly by emission intensity.” (emphasis added)
The report’s authors concluded with the notion that ESG investing is still novel and an effective approach to using investment as a tool against climate change has yet to be developed.
“To summarize, investors seem to take a somewhat schizophrenic attitude to carbon emissions. On the one hand, institutional investors clearly want to take a proactive approach by divesting from industries with high CO2 emissions. On the other hand, this categorical exclusionary screening approach only partially addresses the carbon risk issue. Indeed, investors price in a carbon emission risk premium at the firm level in all industries even though divestment is concentrated in the industries with the highest CO2 emissions (oil & gas, utilities, and motor industries). The challenge with carbon risk is that it cannot just be reduced to a fossil fuel supply problem.”
The problem does not necessarily lie with the companies producing fossil fuels, but rather with us as consumers who still depend on the resource for powering our every day life and modern economy and commerce.
“Once one factors in both supply and demand aspects, all companies are sinners to various degrees when it comes to carbon emissions. A coarse exclusionary approach focusing only on the energy and utility sectors (and using emission intensity as the main filter) misses the full extent of the CO2 emissions problem. Accounting for carbon risk is also required on the demand side, so to speak, which inevitably involves the careful tracking of emissions at the firm level.”
The paper concludes what we already knew—that divestment is just not an effective tool to addressing concerns about climate change and doesn’t impact targeted companies. The fact of the matter is that fossil fuels are an integral part of our global economy and selling a few stocks to a willing buyer will not change that fact. While companies are continuing to look for opportunities to reduce their emission profile and invest in new technologies, it’s incumbent upon all of us to focus on solutions instead of empty gestures.
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