Research: Understanding the cost of going green
For many companies, shifting their operations to become greener and more environmentally friendly carries significant risk and cost. This uncertainty expands beyond the company and can potentially impact shareholder value and market performance.
A new study by Shaojun Zhang, assistant professor of finance at Fisher, sheds new light on the complex relationship between this risk and investment returns. The paper, "The Pricing of Carbon Transition Risk," challenges previous assumptions and provides fresh perspectives on how carbon emissions impact financial markets.
Understanding carbon transition risk
Carbon transition risk refers to the financial risks associated with the global shift toward a low-carbon economy and can be measured by carbon intensity or emissions scaled by sales. As governments and industries implement stricter climate policies, more carbon-intensive (brown) firms face increased regulatory and operational challenges. Conversely, lower carbon-intensive (green) firms are better positioned to succeed in a carbon-conscious market.
Key findings of the research
Zhang's study reveals that green firms, measured by carbon intensity, generated higher equity returns than brown ones in the U.S. in the past few years. The outperformance of brown firms documented in previous studies does not reflect the pricing of carbon transition risk. Instead, it comes from researchers using forward-looking emission data too soon. This insight is crucial for investors aiming to make climate-aware investment decisions.
Data release lag and its impact
The study places a strong focus on the lag in carbon data release. Emissions grow almost one-for-one with firm sales and are often reported with a delay. As such, firms with high sales growth will have higher total emissions, resulting in a “browner” profile and stronger contemporaneous stock performance. This seeming outperformance of brown stocks should not be interpreted as evidence that the carbon transition risk is priced in financial markets. By accounting for this data release lag, Zhang finds that green firms outperformed brown ones in the U.S. in recent years and yielded similar performance globally.
Cross-country variations in carbon returns
The research highlights significant regional differences in carbon returns defined as the relative performance of brown stocks. Developed markets, such as the U.S., exhibit lower carbon returns as investors become more concerned about climate issues. Meanwhile, countries with stringent climate policies show higher carbon returns, reflecting compensation for heightened policy risk. This variation underscores the importance of understanding location, local climate policies and investor sentiment when assessing carbon transition risk.
Methodology and robustness
Zhang's analysis incorporates various measures of carbon transition risk and conducts multiple robustness checks. The study uses firm-level climate performance data from S&P Trucost, stock market, and accounting data from CRSP and Compustat, and additional data from sources like the World Bank and Climate Change Performance Index. The sample covers data from June 2009 to December 2021, providing a comprehensive view of the evolving carbon landscape.
Implications for investors
For investors, the study offers valuable insights into the pricing of carbon transition risk. The carbon intensity measure is superior to total emissions in capturing the transition risk because it distinguishes firms’ carbon footprint from firm size and operations. This finding has significant implications for asset managers and investors committed to sustainable investing.
“The global transition toward full carbon-aware investments is still underway,” Zhang said. “By understanding the true pricing of carbon transition risk, investors can make more informed decisions about their financial wealth and support for carbon reduction.”
A critical aspect of Zhang's research is the role of forward-looking sales information in emissions data. Emissions are closely linked to firm sales, which explains much of the variation in emissions. When evaluating the pricing of carbon transition risk, investors need to lag the emission data sufficiently. The outperformance of brown firms documented in previous studies is due to the strong performance of brown firms during the emitting period, not a risk premium. This insight is essential for understanding the true drivers of carbon returns.
“The study also has implications for policymakers,” Zhang said. “More timely and transparent emissions reporting could improve market efficiency. Policymakers could use these insights to design better regulations that encourage accurate and timely disclosure of emissions data.”
The research marks a significant step forward in understanding the financial implications of carbon transition risk. By challenging existing assumptions and providing a nuanced analysis of emissions data, the study paves the way for more informed and effective climate-aware investment strategies. As the global economy continues to transition towards sustainability, these insights will be invaluable for investors navigating the complexities of carbon risk.
