The carbon risk premium
Is there one? Are carbon emissions perceived to be a systematic risk factor? Are financial markets pricing carbon risk inefficiently? How do investors identify the firms to be divested from? These are the questions Bolton and Kacperczyk are trying to answer in this paper. Their main findings are:
- The carbon premium is economically significant: Insurance companies, pension and mutual funds are underweight scope 1 emission intensity;
- Exclusionary screening by investors is done entirely in industries with the highest CO2 emissions, in all other industries there is no significant divestment.
Their main conclusion:
If there is one general lesson that emerges from our analysis it is that carbon risk cannot just be reduced to a fossil fuel supply problem. It is also a demand problem. Once one factors in both supply and demand aspects, all companies in all sectors are exposed to various degrees to carbon emissions risk. A coarse exclusionary approach focusing only on the energy and utility sectors misses the full extent of the problem investors face. Accounting for carbon risk is also required on the demand side, which the careful tracking of emissions at the firm level in all sectors.
Carbon emissions from a company’s operations and economic activity are typically grouped into three different categories: direct emissions from production (scope 1), indirect emissions from consumption of purchased electricity, heat, or steam (scope 2), and other indirect emissions from the production of purchased materials, product use, waste disposal, outsourced activities, etc. (scope 3).
Do Investors Care about Carbon Risk?
Authors: Patrick Bolton, Marcin Kacperczyk
From: Columbia University, Imperial College
Sustainable investments and their social impact
In this paper Pástor et al. consider the implications of investing according to ESG criteria. They use an equilibrium model which features many heterogeneous firms and agents: firms differ in the sustainability of their activities and agents differ in their preferences for sustainability, or “ESG preferences.” Their model highlights the key channels through which agents’ preferences for sustainability can move asset prices, tilt portfolio holdings, determine the size of the ESG investment industry, and cause real impact on society. Among their conclusions:
- ESG preferences move asset prices: Green stocks’ expected low returns stem from two sources: investors’ tastes for green holdings and such stocks’ ability to hedge climate risk;
- Green assets outperform when there are positive “shocks” such as the ones generated by customers who shift their demand for goods of green providers contribute to the outperformance of green assets;
- Sustainable investing generates positive social impact, in two ways. First, it leads firms to become greener. Second, it induces more real investment by green firms as it lowers their cost of capital, and less investment by brown firms.
Sustainable Investing in Equilibrium
Authors: Lubos Pastor, Robert F. Stambaugh, Lucian A. Taylor
From: University of Chicago, University of Pennsylvania
ESG and firms’ decision making
With the rise of interest in ESG issues, should the max shareholder wealth rule for the decisions of firms be replaced by the max shareholder welfare? No, argues Eugene Fama for two reasons:
- In contrast to the Bolton and Kacperczyk paper above, consumer-investors view max welfare from the perspective of their overall consumption-investment portfolios, not security-by-security;
- Firms are not privy to the total ESG exposures of their consumers and investors, and are typically in the dark on how to move them toward max welfare, as a result max wealth is the appropriate decision rule.
In conclusion: a portfolio perspective points to max shareholder wealth as the appropriate decision rule for firms even when consumers and investors have strong tastes for ESG virtue. Firms are rewarded for ESG virtue via higher prices for their products and securities, and firms max shareholder value given these prices.
Contract Costs, Stakeholder Capitalism, and ESG
Author: Eugene Fama
From: University of Chicago
