Can Companies' Carbon Emissions Affect Their Stock Performance?  

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Can Companies' Carbon Emissions Affect Their Stock Performance?  

Does investing in an environmentally friendly manner mean you may need to accept lower returns? Unfortunately, the answer to this question is complicated. Here’s why…

Published by Motley Fool Wealth ManagementWed, Apr 20, 2022

read time 5 min read

Are companies that emit large amounts of greenhouse gas bad long-term investments?

 That question is at the heart of whether investing in an environmentally friendly manner means you may need to accept lower returns.

 Fortunately, some academic minds want to know, too, so they’ve been researching this exact question. It's also been on the minds of the Securities and Exchange Commission. On March 21, 2022, the SEC unveiled a new plan that would require companies to provide detailed information on their greenhouse gas pollution. Some companies also may need to disclose information on emissions for firms in their supply chains. Currently, more than 13,000 companies already disclose climate-related information.1

There are three schools of thought

Not surprisingly, different investors have different expectations about carbon emissions as a factor in investing. One is that these stocks will eventually underperform, and investors should avoid them. Another is that while there is a risk to investing in high-greenhouse gas (GHG) emitters, in the near term, these companies will outperform, granting investors a premium return for taking on this extra risk—a risk premium. (Not to get too into the weeds, but the financial model that prices assets uses the risk premium as an input.) Still, others believe that there will be no effect on the stock’s performance because there is little risk to company operations from GHG emissions. As a result, not enough investors will shun them to make a difference, or markets are simply inefficient and do not reflect the risk yet. 

And the research shows (cue the drumroll)…

Carbon emissions matter, but investors may receive a premium for taking on the risk.

One study found that “stocks of firms with higher total CO2 emissions (and changes in emissions) earn higher returns, controlling for size, book-to-market, and other return predictors. Overall, our results are consistent with an interpretation that investors are already demanding compensation for their exposure to carbon emission risk.Another study on how a company’s long-term average carbon emission growth rate, or carbon momentum (CM), affected stock returns between 2008 and 2020 in 22 international markets backed this conclusion.

Furthermore, the studies conclude that the premium can be significant.2 Of course, all investments involve risk and the premium is not guaranteed—there is no telling when it may disappear or turn negative.

But a third study came along and debunked these two findings. This study challenges the connection between GHG emissions and stock performance or a risk premium. It concluded that a poorly designed methodology determined the associations. Therefore, unscaled emissions links with stock returns and operating performance disappeared when the data accounted for firm size and how the emissions were disclosed (by the company vs. a vendor). The study reiterates that “Investors might want to be cautious about assuming that carbon emissions are priced by equity markets.”

Why do we bring this up?

Most investors would like to use their money to do good in the world while also making a profit. But unfortunately, it's hard to decipher what is real and what isn't because many strategies prey on this “do good, feel good” mentality.

We’re not here to debate which of these studies has accurate findings. But there is a lesson learned.

That old saying "garbage in, garbage out" means a lot here. Environmental, social, and governance (ESG) investing is growing. But as with any new venture, it has had its share of growing pains. And one of those is the data used to inform the analysis. The last study specifically cited that the party that supplied the data (a vendor or the company) made a difference. It appears vendors incorrectly tied the relationship between carbon emissions and profits while companies had a more realistic view.3 Unfortunately, many ESG strategies—mainly passively managed mutual funds and ETFs—rely heavily on vendor data. This often can translate into investors not getting what they thought they would.

So while we applaud large-scale research that can tell us big trends, we recognize that studies based on big data take time and repetition to become conclusive. Methods need to be analyzed and challenged by other researchers.

And perhaps more importantly, we believe there’s a different solution

We think direct research based on speaking personally to company management and independently reviewing company filings has an exceptional value when done right. That’s our method. Our investment team at Motley Fool Wealth Management interviews company management, scours through company reports, compares what they're saying to what competitors are doing and saying, and strives to draw a complete picture of its profitability potential and possible risks. That's the difference between relying on external sources of information and going straight to the original.

Another strong belief? While ESG may be a blossoming trend, we’ve been investing with that mindset since our inception. It’s part of our Four Pillars of Quality framework.

For example, one of the pillars is Trajectory. Here we break out our crystal balls and attempt to understand where the economy may be in 10 years. In that context, we try to assess how a company’s strategy and business model could impact it a decade down the road.

Could its technology give it a leg up in a more environmentally focused world? Are there risks from a potential new government policy? Will the company be forced to change its operations in the face of shareholder activism?

Obviously, we cannot foretell the future. But this thought exercise helps us become more comfortable with our investment theses and intention of holding companies for the long term.

As we said, these considerations are not new—they’ve been a foundational part of our process since day one. Moreover, it's one of the many inputs that go into our goal of owning high-quality companies that have the potential to sustain their competitive advantages for years, if not decades, to come.

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Sources:

1 Bloomberg

2Swedloe, 2/7/22, Advisor Perspectives. “The carbon premium is economically significant: A one-standard-deviation (SD) increase in the level and change of scope 1 emissions leads to a 1.8% and 3.1% increase, respectively, in annualized stock returns. A one SD increase in the level and change of scope 2 emissions leads to a 2.9% and 2.2% increase in annualized returns. And a one SD increase in the level and change of scope 3 emissions increases stock returns 4.0% and 3.8% on an annualized basis.”

3 Walkshäusl, “Carbon Momentum,” Fall 2021 issue of The Journal of Impact and ESG Investing. https://jesg.pm-research.com/content/2/1/33. This study separated this data and re-ran the testing, the risk premium (better stock performance) only showed up using the data from vendor estimations. When the researchers analyzed the vendor data, they found the vendors' method for estimating a company's GHG emissions strongly correlated to company sales and assets, which correlated to higher stock performance.

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