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Is 'Being Green' Rewarded in the Market?: An Empirical Investigation of Decarbonization Risk and Stock Returns

TitleIs 'Being Green' Rewarded in the Market?: An Empirical Investigation of Decarbonization Risk and Stock Returns
Publication TypeWorking Paper
Year of Publication2017
AuthorsIn, SYoung, Park, KYoung, Monk, A
KeywordsWorking Paper
Investors increasingly prioritize climate finance and look for investment opportunities that offer “high returns with high environmental impact.” After analyzing 74,486 observations of U.S. firms from January 2005 to December 2015, we find that such investment opportunities do exist. In this study, we empirically examine not only the relationship between firm-level carbon intensity and stock returns, but we also investigate firm characteristics. We use firm-level carbon intensity, defined as the actual amounts of greenhouse gas (GHG) emissions divided by a firm’s revenue, to construct a carbon efficient-minus-inefficient (EMI) portfolio. Our benchmark EMI portfolio produces a large positive cumulative return after 2009, and its return cannot be explained by other risk factors, such as size, value, momentum, and operating profitability, thus generating positive alpha. Our investment strategy of “long carbon-efficient firms and short carbon-inefficient firms” would earn abnormal returns of 3.5–5.4% per year. Furthermore, we double-sort portfolios by book-to-market ratio (B/M) and carbon intensity, and firm size and carbon intensity. We confirm that double-sorted EMI portfolios earn a positive alpha of similar magnitudes. The only exception is that small efficient firms do not outperform small inefficient firms. We find that carbon-efficient firms are “good firms” in terms of financial performance (measured by Tobin’q, ROA, ROI, cash flow and coverage ratio) and corporate governance (measured by free cash flow and cash holdings). However, portfolios based on improvement in carbon efficiency do not show similar results, suggesting that investors do not explicitly consider carbon efficiency—and their changes—in their investment decisions. Our findings are not driven by a small set of industries, variations in oil price, or changing preferences of bond investors caused by low interest rates regime starting with the 2008 financial crisis. We discuss the implications of our findings for mobilizing investment in carbon-efficient firms. 

CSR (Corporate Social Responsibility), ESG (environmental, social, governance), decarbonization, carbon emission, multi-factor asset pricing models, EMI (carbon efficient-minus-inefficient) portfolio