New research shows that bonds from carbon-emitting (“brown”) companies have underperformed those of green companies during last 13 years, but, contrary to theory, they are riskier. Indeed, brown bonds may outperform in the future, as the temporary effect from increased investor demand subsides.
Traditional asset pricing theory predicts that investors should demand higher expected returns for holding securities issued by carbon-intensive firms to compensate investors for their higher exposure to carbon risks (the “carbon risk premium” hypothesis). However, the empirical evidence on equities is somewhat ambiguous, with some studies finding a carbon premium and others not. Investor preferences lead to different short- and long-term impacts on asset prices and returns. Firms with high sustainable investing scores earn rising portfolio weights, leading to short-term capital gains for their stocks – realized returns rise temporarily. However, the long-term effect is that higher valuations reduce expected long-term returns. The result can be an increase in green asset returns even though brown assets will earn higher future expected returns.
In other words, there is an ambiguous relationship between carbon risk and returns in the short term.
As Maximilian Görgen, Andrea Jacob, Martin Nerlinger, Ryan Riordan, Martin Rohleder and Marco Wilkens, authors of the 2020 study, “Carbon Risk,” noted: “Over time as the markets develop a better understanding of carbon risk and the unexpected component falls relative to the expected component, we should expect a positive relationship between returns and carbon risk.” Without this understanding, investors can misinterpret findings that appear to show the lack of a carbon premium. There was an ex-ante carbon premium, but the ex-post results showed a negative premium because of cash flows raising valuations of green companies. Given the continued trend in sustainable investing, it will be a while before we reach a new equilibrium. In the meantime, despite investors requiring a risk premium for carbon risks, green stocks can outperform brown ones.
Tinghua Duan, Frank Li and Quan Wen contribute to the sustainable investing literature with their November 2020 study, “Is Carbon Risk Priced in the Cross Section of Corporate Bond Returns?” The data sample was based on carbon emissions data from Trucost and corporate bond pricing data from the enhanced version of the Trade Reporting and Compliance Engine (TRACE). They examined the relation between a firm’s carbon emissions intensity (CEI) – carbon dioxide (CO2) emissions in units of tons scaled by a firm’s total revenues – and the expected return on its corporate bonds. Since the baseline level of carbon emissions varies intrinsically across industries, they formed value-weighted quintile portfolios within each of the 12 Fama-French industries to control for the industry effect and to calculate the average portfolio returns across industries. Their sample covered the period July 2006 through June 2019. Following is a summary of their findings:
- The bonds of high CEI firms are riskier on average than those of low CEI firms, as indicated by a higher bond market beta, downside risk, higher illiquidity and lower credit ratings.
- Firms with higher CEI have more negative cash flow surprises and deteriorating creditworthiness in the future.
- Firms with low (high) CEI experience a reduction (increase) in their probability of financial distress in the future.
- Despite their greater risk, the bonds of high CEI firms significantly underperformed the bonds of low CEI firms. The low carbon premium effect was economically significant: Corporate bonds in the lowest CEI quintile generated 1.7% (t-stat = 2.62) per annum higher returns than bonds in the highest CEI quintile.
- Regardless of the factor model used, the low-CEI portfolio significantly outperformed the high-CEI bond portfolio, with a monthly nine-factor (five equity factors and four bond factors) alpha ranging from 0.13% to 0.16%.
- The return spreads between the low- and high-CEI portfolios were larger for non-investment-grade and longer-maturity bonds but remained significant for investment-grade and shorter-maturity bonds.
- The results remained similar when they constructed their CEI measure based on the scope 2 emissions as well as scope 1 and scope 2 emissions combined. In addition, the most carbon-intensive industries do not drive the low carbon premium – when they excluded the most carbon-intensive industries, including the energy, chemicals and utilities industries, the return spreads between low- and high-CEI bonds remained economically and statistically significant.
- Institutional investors collectively divest from bonds issued by carbon-intensive firms.
Duan, Li and Wen did acknowledge that excess demand from ESG-conscious investors could boost the realized performance of green assets, while hurting that of brown assets: “If one computes average returns over a sample period when ESG concerns consistently strengthened more than investors expected, green assets could outperform brown assets.” To investigate the implications of ownership changes for future bond returns, they examined whether the bond return predictability of CEI can be fully explained by shifts in institutional demand. They found: “The predictive power of carbon emissions intensity for future bond returns remains significant, suggesting that shifts in institutional preference toward low carbon assets cannot fully explain the outperformance of bonds from low carbon emissions firms.” In support of this hypothesis, they found that “firms with lower carbon emissions intensity are associated with higher future earnings and revenue surprises, but investors fail to fully incorporate the information they glean from firms’ emission intensity when forming their expectations about future earnings. As a result, investors are systematically surprised when fundamental information is subsequently disclosed to the market via earnings announcements. In further support of this channel, we find firms with low (high) carbon emissions intensity subsequently experience improved (deteriorating) creditworthiness.”
Duan, Li and Wen also found that a reason carbon-intensive firms experience lower cash flows is that environmental risks are persistent, i.e., carbon-intensive firms are more likely to face negative environment incidents than carbon-efficient firms – CEI is predictive of more frequent environmental incidents in the future. They stated: “These results are broadly consistent with the ‘investor underreaction’ hypothesis which posits that risk associated with carbon emissions is underpriced in the corporate bond market as measured by bond credit ratings and the O-score.”
The finding of underreaction is consistent with that of Simon Glossner, author of the 2017 study, “ESG Risks and the Cross-Section of Stock Returns,” and those of Bei Cui and Paul Docherty, authors of the 2020 study, “Stock Price Overreaction to ESG Controversies.” It also provides an example of how markets are not perfectly efficient and how anomalies can persist due to behavioral errors investors persistently make, and the presence of limits to arbitrage.
Their findings led Duan, Li and Wen to conclude that CEI, “is a strong and robust predictor of future bond returns.” They added: “Our finding of a low carbon premium, combined with the evidence that bonds of carbon intensive firms are riskier, suggests that the data do not support the ‘carbon risk premium’ hypothesis.” With that said, they did note: “The low carbon premium declines for the most recent subperiod from 2016 to 2019.” Perhaps the market was becoming more efficient, recognizing the risks from carbon emissions.
Larry Swedroe is the chief research officer for Buckingham Strategic Wealth and Buckingham Strategic Partners.
Important Disclosure: This article is for educational and informational purposes only and should not be construed as specific investment, accounting, legal or tax advice. The analysis contained herein is based upon third party data and information and may become outdated or otherwise superseded at any time without notice. Third-party data and information is deemed to be reliable but its accuracy and completeness cannot be guaranteed. By clicking on any of the links above, you acknowledge that they are solely for your convenience and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party websites. We are not responsible for the content, availability or privacy policies of these sites and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them. The opinions expressed by featured authors are their own and may not accurately reflect those of Buckingham Wealth Partners, collectively Buckingham Strategic Wealth® and Buckingham Strategic Partners®. R-20-1531
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New research shows that bonds from carbon-emitting (“brown”) companies have underperformed those of green companies during last 13 years, but, contrary to theory, they are riskier. Indeed, brown bonds may outperform in the future, as the temporary effect from increased investor demand subsides.
