Many free market thinkers believe that the business of business is business. They scorn investments in companies that look out for the greater good.
But a study by researchers at Stanford University and Korea’s Yonsei University suggests that, at least when it comes to climate change, investors may actually do better with companies that try to do the right thing.
The study, led by Soh Young In, a doctoral candidate in Civil and Environmental Engineering at Stanford, finds that companies that emit less greenhouse gas (GHG) relative to revenue also tend to generate higher investment returns. Specifically, they found that a strategy of buying “carbon-efficient” companies and selling “carbon-inefficient” ones boosted returns between 3.5% and 5.4%.
The researchers also found that, in general, low-carbon companies have better underlying financial performance. They tend to show higher returns on investment, better cash flows and better ability to cover their debt obligations. They are also more likely to rate high on measures of good corporate governance.
“Professional money managers may worry that efforts to reduce GHG emissions will interfere with the goal of maximizing profits, and thereby breach their fiduciary duties,” In says. “But our results indicate that investors can actually earn higher returns from companies that reduce their carbon footprints — even if there are no government incentives to do so. More importantly, these higher returns come without a corresponding increase in risk. This is what analysts call alpha returns.”
The researchers — who included Ki Young Park, an associate professor in economics at Yonsei University, and Ashby Monk, executive director of Stanford’s Global Projects Center — began their study by comparing the carbon efficiency of 736 publicly traded U.S. companies, from 2005 through 2015, in a range of industry sectors such as energy, health care and information technology. The researchers got their emissions data from Trucost, a unit of S&P Dow Jones Indices, which tracks emissions from thousands of companies — not just at their own facilities but all the way down their supply chains.
To ensure apples-to-apples comparisons, the researchers defined carbon efficiency as the amount of a firm’s GHG emission divided by its revenue, and compared companies in the same industries. They then created model investment portfolios, called “efficient-minus-inefficient” (EMI) portfolios. Their model strategy was based on going long on companies in the top third on carbon-efficiency and short on companies in the bottom third. In a further extension of their apples-to-apples approach, they made these comparison in each industry and each year. They found that carbon-efficient firms started outperforming carbon-inefficient firms from 2009 or 2010, delivering abnormally high returns that could not be explained by standard risk factors such as market, size, value, momentum, profitability and investment. The results held for most kinds of companies, except for very small ones.
Interestingly, the researchers found that falling oil prices didn’t undermine the low-carbon investment returns. That’s a bit surprising, because lower oil prices reduce the immediate benefits of switching to renewable fuels or more efficient equipment. The research also checked whether a change in investor preference caused by unconventional monetary policy explains the outperformance of carbon-efficient firms. Due to extremely low interest rates after the 2008 financial crisis, bond investors moved their funds to equity markets, favoring stable industries that pay high dividends such as utilities, telecommunications, information technology and consumer staples. In a further validation of their findings, performance of EMI portfolios with and without these industries were similar, suggesting that the positive effect of the carbon-focused strategy was not attributable to post-crisis changes in investment patterns.
The remaining questions are why the outperformance of carbon-efficient firms started around 2009 or 2010 and if it will persist in the future. In says it’s not clear why 2009 or 2010 looks like an inflection point, and noted that results are being published as a working paper, which is the researchers’ way of saying it’s a work in progress.
But the researchers believe that the payoff from low carbon investments isn’t some flash in the pan.
“We admit that our results are for a relatively short period of time and need to see if this pattern will persist,” she said. “But the characteristics of carbon-efficient companies we find are not things that change much from year to year.”