Climate Shocks and Green Returns

New research examines the relationship between climate change-related events and returns on green investment, and why returns for green stocks might lag those of brown.

At first look it would seem to make sense that, as climate concerns grow, green investments would outperform investments in dirty industries.To put this into an energy context, as policymakers require more renewable energy to be deployed, and as investors flock to companies with low climate impacts and risks, the value of those companies would substantially increase, rewarding investors through
higher returns.

Yet recent research suggests that this assumption may not be true. Or, at least, that the story isn’t as clear-cut as one might intuitively expect. 

Luke Taylor, a professor of finance at the Wharton School, explores the drivers of green returns. In new research, Taylor and coauthors look at the past decade of returns on ESG portfolios, and at how environmental policies, and investor demand for all things green, combined to influence returns on green stocks. 

Andy Stone: Welcome to the Energy Policy Now podcast from the Kleinman Center for Energy Policy at the University of Pennsylvania. I’m Andy Stone.

It makes intuitive sense that, as climate concerns grow, green investments would outperform investments in dirty industries. To put this into the context of this podcast, as policy-makers require more renewable energy to be deployed, and its investors flock to companies that produce green products that are expected to be in ever increasing demand, the value of those technologies and products would increase, rewarding investors through higher returns. Yet recent research suggests that this assumption may not be true, or at least that the story isn’t as clear-cut as one might intuitively expect.

On today’s podcast, I’ll be exploring the drivers of green returns with Luke Taylor, a Professor of Finance at the Wharton School at the University of Pennsylvania. In new research, Taylor and co-authors look at the past decade of returns on ESG portfolios and how a variety of forces, from federal and state environmental policies to consumer and investor demand for all things green, combine to produce some surprising financial outcomes. Based on that experience, Taylor will explore how ESG policy and investors’ motivation to do good by going green may lead to unexpected investment outcomes and, by extension, influence the flow of capital into green industries in years to come. Luke, welcome to the podcast.

Luke Taylor: Hi. Thanks for having me.

Stone: I wonder if you could get us started by talking about your research. You and a pair of co-authors examined the return on ESG investment or portfolios over the past decade. Fundamentally, what did you find?

Taylor: I should mention my co-authors on this project are Lubos Pastor at the University of Chicago and Rob Stambaugh, my colleague here at Wharton. In a nutshell, what we find is that over the last decade, green assets massively outperformed brown assets, but that outperformance was unexpected. In this project, we wanted to study these returns of green versus brown assets, and to do that, we focused in on the “E” part of ESG. We focused on environment. We’re going to define a green stock as the stock of an environmentally friendly company and brown as the stock of an environmentally unfriendly company. What we expected to find was — well, we expected green assets to underperform. That prediction came from some economic logic. It came from a theory paper we had written, and according to economic logic, green assets should have lower expected returns.

The reason is there are these ESG investors out there who like holding green assets, so they’re willing to accept a lower expected return to hold them, and vice-versa. They really dislike holding brown assets, so you’re going to have to offer them a higher expected return to induce them to hold them. So we should expect green to underperform. But when we looked at the data, we saw the exact opposite. We saw that green massively outperformed brown from the years 2013 to 2020. They outperformed by, I think it was 174 percentage points over eight years. So that got us wondering: What was wrong with our logic?

To answer that, we tried to understand why. Why did green assets perform so well? And we realized there was something very special about those years. What was special is that there was this huge awakening to the crisis of climate change. Basically we all became much more concerned about climate change, and as we became more concerned, that led customers to buy more green products, buy fewer dirty products — possibly prompted by government regulation. It also probably prompted a lot of investors to become ESG investors and prompted huge flows of money into green stocks and outflows from brown stocks. So that was possibly what happened.

To test that, we had to go out and measure people’s concern about climate change, and we did that using a data series by another team of co-authors, Dave Hardy and co-authors. They measured the level of concern about climate change every day during this period. And they do that by machine-reading the eight top newspapers, counting the number of stories about climate change, measuring how much concern and risk those stories express. What we find empirically is that on days when there was an unexpected amount of scary climate change news, green stocks outperformed brown stocks. In other words, bad news about the climate is good news for green.

And that kind of makes sense, right? If we all become more concerned about climate change, we probably expect governments to act, and they’re probably going to act in a way that favors green companies and maybe penalizes brown companies. So that’s about climate risk. What that result shows is that climate risk really moves stock prices. These shocks concerned about climate moved stock prices.

So then we decided we wanted to go a step further, and we asked: What if those eight years had been different? What if we could replay history and do it differently?

Stone: Without the shocks.

Taylor: Without the shocks. What if we could go back in time and turn off those climate-concerned shocks? What if we hadn’t become more concerned about climate? We can do that with our simple model. What we find is that when you turn off these climate-concerned shocks, the outperformance of green stocks completely vanishes. In fact, in certain specifications, green stocks would have underperformed, had we not become so concerned about climate.

Stone: What’s the basis of that underperformance?

Taylor: Well, theory tells us we should expect them to underperform. Our original prediction was that we expect green to underperform. And it’s kind of nice once we take all the shocks out, they do underperform, consistent with economic logic — but just by a little bit. This is the basis of our main result, which is that the only reason green stocks outperformed is that there were these huge shocks, unexpected shocks, that hit during this period.

Stone: Explain to me what is that economic logic that predicts underperformance? I’m not sure if I understand that.

Taylor: So here’s the logic. There are some ESG investors out there. They like holding green stocks. That bids up the stock price for green stocks. Their extra demand bids up the stock price for these green stocks. That means today, or at the beginning of our sample in 2013, green stocks had high prices. Having a high price today is the same as saying having low expected returns in the future. They’re the same thing. And conversely, the ESG investors really dislike holding, for example, coal stocks. That reduces the demand for coal stocks. That means those coal stocks have a low price today; equivalently, they have high expected returns in the future.

Stone: Let’s talk a little bit more about these shocks. You mentioned policy in there. When we look at climate shocks, we can be looking at natural disasters, flooding, fires, wildfires; but we can also be talking about policy developments. What are the shocks primarily that you’re discussing here?

Taylor: We took a closer look by taking this measure of climate concern and breaking it into its parts. For example, we can measure new stories about natural disasters. We can measure new stories about government summits, about regulation. And to our surprise, we found that news about natural disasters did not move stock prices — green versus brown. What really moved green versus brown returns was news about regulation, climate-related regulation and news about climate-related government summits.

Stone: So the plot thickens here, and this is something you pointed out in the paper we’ve been referencing so far, and also in a, I guess a companion piece of research that came out a little bit earlier. We’ve talked about market pricing in ESG factors and the importance of shocks in driving unexpected returns for green assets, green companies, green stocks. But there’s a second critical element here, and that is as more money is directed to green companies, the cost of capital for those same companies falls. And that is good for the companies, but maybe not so great for investors. I wonder if you could talk about that phenomenon.

Taylor: I’m glad you brought this up, because I think there’s a lot of confusion out there about this exact point. I think what a lot of people forget is that the expected return on a stock is exactly the same thing as the cost of capital for that stock. These are exactly the same concepts. And it’s funny because I’ll often hear, especially ESG investors say, “I’m holding this green portfolio. I expect it to perform better than the market, yet I’m reducing the cost of capital for green companies.” And when you hear people say that, that should immediately strike you as logically inconsistent. It’s a contradiction. You can’t have a high expected return and a low expected return, right?

So what our research implies is that — it gets exactly to this question of: Do greener companies have a higher cost or capital or a lower cost of capital? Our research implies greener companies have lower costs of capital, and that’s equivalent to having lower expected returns. It’s the same as saying, “I expect these green stocks to underperform brown stocks.” It’s also equivalent to saying, “Green companies today, all else equal, have a higher price today.” Having a high price today is the same as having low expected returns in the future.

So it’s like saying, “Look, green stocks benefit from ESG investors because these ESG investors give green companies a high stock price today.” Equivalently, it gives them lower cost of capital. And that’s not just good news for the company. It’s also good news potentially for the environment, because I think what many ESG investors intend to do by tilting green is that they intend to lower the cost of capital for a green company. They intend to increase the cost of capital for dirty companies. Now whether they’re moving the needle quantitatively remains to be seen, but at least directionally, this is good news for the environment because it should shift capital, and it should shift economic activity away from dirty companies and toward cleaner companies.

Stone: I think the key question here then is: Also is that enough of a shift to have a material impact on emissions and the environment?   

Taylor: That’s the key question. It’s something that we don’t know yet, and it’s being researched as we speak, including here at Wharton. I would highlight a recent research paper by one of my Wharton colleagues, Jules van Binsbergen, who tries to answer exactly that question and ask, “Is divestment from dirty companies going to move the needle quantitatively?” And what he finds is the answer is no, unfortunately. He finds even if a huge fraction of investors were to divest completely from dirty companies, it’s just not going to change the cost of capital that much for those companies. It’s not going to move the needle on those companies. Investment decisions are just not going to shift that much capital away from dirty companies and toward cleaner companies.

Stone: All right, Luke, so let me ask you kind of a related question on that cost of capital effect. If what you’re saying here is that as more money flows into green companies, their cost of capital falls, so it’s cheaper for them to raise capital, and therefore they invest more, right? They theoretically grow more quickly. From the investors’ standpoint, as that cost of capital falls, their returns also decline. Does this thereby disincentivize investment into these companies, which would be a counter to the cost of capital, the cheap cost of capital effect?

Taylor: It could. I think there are a lot of ESG investors out there who think they can have their cake and eat it, too. They think they can simultaneously lower the cost of capital for a green company while expecting to outperform the market. And we’re coming in, and we’re — I guess you could say we’re raining on their ESG parade, and we’re saying, “Look, you can’t have your cake and eat it, too.” We think what’s most logical and consistent with the data is that when money floods into ESG investing, it does lower cost of capital for green companies. That’s good for the environment. But it also, like you suggested, it lowers those ESG investors’ forward-looking expected returns.

So it’s possible there are some people who didn’t understand that, and if we’re raining on their parade and we’re making ESG less attractive to them than they had previously thought, that could disincentivize some ESG investment, but we think it’s nevertheless an important message to get out there because we think people should be making informed choices.

Stone: I want to bring up another point. Seemingly missing from this whole discussion is direct consideration of the issue of climate risk, okay? Relative to all that we’ve discussed, to what extent is climate risk itself material to returns, particularly for companies such as those in fossil fuels and chemicals? Is that risk already baked into the market? And my intuition is that maybe it’s not.

Taylor: Sure, we have a lot to say about climate risk. This measure of climate concerns, these shocks that we measure in our study, you could call those “realizations of climate risk.” And what we show is that climate risk shocks that arrived during this ten-year period really moved stock prices. In fact, they moved stock prices so much that they made green stocks outperform, even though we would have expected them to underperform.

Now you ask another interesting question, which is: Are climate risks baked into prices already? If you think markets are efficient, then you would think that, yes, all stock prices reflect our expectations of how bad climate is going to get in the future. All those expectations should be baked into stock prices today in an efficient market.

Stone: So ESG portfolios often include individual companies that we might not think of as green. I’m thinking of companies like Apple and Alphabet, which show up in a lot of green mutual funds and ETFs but aren’t green in the same way that a renewable energy company is. If we were to take a narrower view of what constitutes green, would the findings we discussed so far still hold?

Taylor: That’s a good question. ESG measurement is a huge challenge, something we’re still learning a lot about. We did look into that question a little bit. We found there were big differences across industries in how green or brown they were. And it makes sense once you think about it. We found that the most brown industries were the chemicals industry; the oil and gas industry; steel; metals and mining, which would include coal; paper and forest products; marine transport. We know these are industries that have huge environmental impacts and pollute a lot.

What was a little more surprising was what was on the green end of that distribution. We found the greenest industries were the asset management industry; the services industry; the telecom industry, which would include a lot of tech stocks; healthcare industries. So that prompted us to look closer and look at maybe a narrower definition of greenness, like you suggested. And the way we looked a little more narrowly is we said, “You know, let’s measure green versus brown differently. Let’s now measure green versus brown relative to other companies in your industry.” So you might take a chemicals company and label it “green” if it’s greener than other chemicals companies. And so we tried doing it that way, with an industry green score, and what we found is that a lot of our results got much weaker. When we do it within an industry in that way, you don’t see much outperformance of green versus brown. So really what we were finding is that it was green industries that massively outperformed brown industries over this period of time.

Stone: So we talked earlier about shocks, policy shocks and their impacts on returns. What policy shocks might we see in the coming decade, and how big will these shocks need to be to increase green returns relative to brown?

Taylor: I think the most important policy shocks are going to relate to when and how much our governments around the world are going to act on climate change. They’re already acting to some degree, but how much are they going to ramp that up, and when are they going to ramp that up? I think that’s broadly the huge question out there. According to our estimates, green stocks are expected to underperform going forward, but not by much — not by much. It wouldn’t take much of a shock to overcome that expectation and result in further outperformance of green stocks relative to brown.

So I should be clear. We are not saying that we’re certain green is going to underperform going forward. We’re saying we expect green to underperform. We’re saying the reason green outperformed in the past decade is green stocks, in a sense, got lucky. It’s kind of a sick way to put it. They got lucky in the sense that there was this string of very bad news about climate. We could continue to see a string of very bad news about climate that could lead governments to intervene sooner or to a greater degree, enough so that it could make green stocks continue to get lucky into the future. And it could make green stocks continue to outperform. But if they do outperform in the future, we would argue that outperformance is unexpected. It’s not something a rational person should expect to happen.

Stone: All right, Luke, so a few minutes ago you made reference to the idea that maybe it’s not the best idea to divest from brown companies to get the best, most positive environmental returns, let’s say, and that it may actually be better to maintain investments in those companies to maintain leverage within the direction of those companies. There’s some ongoing research into this area. It’s pretty tricky. I can see the tomatoes flying at this podcast right now for even broaching the subject. I wonder if you could discuss the theory here and what the research is?

Taylor: Like you said, it’s a very interesting and contentious area of research right now. I think the question here is: If you’re an investor, and you want to help the environment, what’s the most effective way to help the environment? I can think of two broad strategies. Strategy number one is divest from the dirty companies, tilt your portfolio toward the clean companies. In theory, this should work, and it works through the cost of capital, right? It reduces cost of capital for green companies and vice-versa for the brown companies. It should work in theory. There is this paper showing that even though it should work in theory, quantitatively the effects are looking really, really small. That’s strategy number one.

Strategy number two is very different. Strategy number two says, “If you want to help the environment, invest in dirty companies.” Use your power as a shareholder, use your vote, for example, as a shareholder, to change the way those companies operate. And try to turn a brown company into a slightly less brown company. We’ve seen this happen. Kind of the classic case on this is the hedge fund Engine No. 1 taking a big stake in ExxonMobil and managing to make some material changes to that company. There’s a lot going for strategy number two, which I’ll call the “shareholder engagement strategy.” One thing it has going for it — there’s a big problem with strategy number one. If you divest from dirty companies, you’re going to sell those shares to somebody. Who is going to buy that share? Probably someone who cares about the environment a lot less than you do. So if you divest from fossil fuel companies, you’re leaving fossil fuel companies in the control of people who care very little about the environment, right? So maybe that’s why strategy number two could be more effective, but like I said, this is contentious. There’s a lot more research needed on the question of: Is it better to divest, or is it better to engage?

Stone: Luke, thanks very much for talking.

Taylor: Thanks, Andy.

Stone: Today’s guest has been Luke Taylor, a Professor of Finance at the Wharton School. His recent paper is titled “Dissecting Green Returns.” Check out the Kleinman Center for Energy Policy website for our archive of more than 140 podcast episodes, as well as research in upcoming in-person and virtual events. To keep up with the center, subscribe to our monthly newsletter on our website. Our address is kleinmanenergy.upenn.edu. Thanks for listening to Energy Policy Now, and have a great day.


Luke Taylor

Professor of Finance
Luke Taylor is a professor of finance at the Wharton School at the University of Pennsylvania.  His recent research paper is “Dissecting Green Returns.”

Andy Stone

Energy Policy Now Host and Producer
Andy Stone is producer and host of Energy Policy Now, the Kleinman Center’s podcast series. He previously worked in business planning with PJM Interconnection and was a senior energy reporter at Forbes Magazine.