If money talks, then investors could surely prod corporations to espouse environmental, social and governance or ESG aspects in how they run their businesses. “Sustainable investing produces positive social impact by making firms greener and by shifting real investment toward green firms,” according to a recent paper titled “Sustainable Investing in Equilibrium,” by finance professors Lubos Pastor at the University of Chicago, and Robert F. Stambaugh and Luke Taylor at Wharton.
In order to achieve those gains, investors are happy to sacrifice on returns. “In equilibrium, green assets have low expected returns because investors enjoy holding them and because green assets hedge climate risk,” the paper stated.
However, they do outperform the rest of the market when there are unexpected shifts in customers’ tastes for green products and investors’ tastes for green holdings, the authors added. The paper provides theoretical guidance for investors and researchers to help them interpret data on ESG investing, said Taylor.
ESG investing totaled $30.7 trillion at the start of 2018 across the five major markets of the U.S., Canada, Europe, Japan and Australia/New Zealand, according to the latest report from the Global Sustainable Investing Alliance. That figure represented a 34% increase over the prior two years in ESG investing.
The ESG Factor
The first key finding of the study is that green assets have higher prices today and therefore they should have lower expected returns in the future. Therefore, green assets should be “bad” investments, since they should underperform, on average.
However, the returns of green assets also depend on what the researchers called the “ESG factor.” The ESG factor could cause green assets to perform well for two reasons. “It could be that consumers become more interested in buying the products and services of green companies, or it could be that investors become more interested in holding green assets. If those changes come as surprises, then green assets can outperform,” said Taylor.
“[ESG investing] increases the amount of green activities in the economy and it reduces the amount of brown activities in the economy.” –Luke Taylor
“If the ESG factor performed well during a 10-year period, then during that 10-year period, you could see green assets outperforming brown assets,” or stocks of companies that do not specifically embrace ESG criteria, Taylor explained. In other words, although the researchers predict that green assets will underperform, “sometimes green assets will get lucky and outperform,” he added.
The luck factor refers to “random events” – events that were unpredictable, said Taylor. For instance, customers may unexpectedly start buying more products of green firms, or it could be that investors unexpectedly care more about green investments. This finding is based on the study’s model and not on an empirical study of returns from stock prices, he clarified.
The study’s observations resonated with the findings of a 2009 paper by Harrison Hong and Marcin Kacperczyk that investors pay a financial cost in abstaining from so-called ‘sin stocks,’ which they define as alcohol, tobacco and gaming stocks. “They show that the sin stocks outperform the non-sin stocks,” said Taylor. “That supports our prediction that green assets, on average, underperform brown assets.”
Another key finding of the paper by Taylor and his co-authors is that ESG investing changes the way that companies behave. “ESG investing has positive social impact,” said Taylor. “That means it increases the amount of green activities in the economy and it reduces the amount of brown activities in the economy.”
ESG investing achieves that in two ways. First, ESG investing reduces the cost of capital for green firms, making it easier for green firms to raise capital and thereby leading them to expand their operations, Taylor said. “So, you would see more expansion in green operations and for the same reason you would see a reduction in the operations of brown firms.”
For example, ESG investing would lead to more wind farms, more solar farms and fewer coal mines, he continued. The second way ESG investing works is by inducing all companies to become greener, because doing so increases their market values. For example, because of ESG investing, a company will choose to install pollution-reducing scrubbers at a coal burning plant, he explained.
“We think this is good news for society and also for ESG investors,” Taylor said. “When people follow these ESG investing strategies, they have a positive benefit on the world. It’s not just about changing stock prices.”
Takeaways for Investors
Investors can create their portfolios with three building blocks, said Taylor. The first building block is a risk-free asset like Treasury bills. The second is the overall stock market, which could be an index fund. The third building block is a passive ‘ESG portfolio’ – “Roughly speaking, it’s a portfolio that goes long green stocks and short brown stocks,” he added.
How can investors use these building blocks to form portfolios? An investor with “average tastes about ESG” should simply combine the risk-free asset with the overall stock market, Taylor said. In contrast, “someone who cares about ESG more than the average investor should tilt their portfolio toward green assets and away from brown assets, by going long the ESG portfolio,” he added. And vice-versa: An investor who cares about ESG less than average should tilt away from green assets by shorting the ESG portfolio.
The paper predicted that an ESG investor’s portfolio should underperform the market, on average. “[However], it’s not that those investors are unhappy; they understand that their portfolio should underperform on average,” said Taylor. “They’re not unhappy because they get satisfaction from holding green assets even though they are expected to underperform.”
“Our theory tells us that roughly half of investors should be buying the brown product, not the green product.” –Luke Taylor
One of the paper’s “more surprising” findings is that the size of the ESG segment increases with dispersion, Taylor pointed out. “The ESG industry is largest when the dispersion in ESG tastes is greatest,” the paper stated. Put differently, the ESG industry wouldn’t exist if all investors cared equally about ESG, because investors would simply hold the overall market portfolio – even if investors cared greatly about ESG.
“So, in order for some kind of ESG investment industry to exist, you must have some dispersion in what people care about,” said Taylor. “If people care a lot about ESG, that’s going to push up the price of green stocks. They’re going to make up a bigger fraction of the overall market.”
Why the Study
Taylor said the context for his study is the “big debate” among academics and in industry over “whether green assets offer good returns.” Studies on the returns from green assets versus non-green, or brown, assets have produced mixed results, he noted. “With our model, we help to resolve that debate.”
Taylor and his co-authors decided to do the ESG investing study because they sensed that the space didn’t have “enough theoretical guidance,” and wanted to provide that to help test and interpret data, he said.
With increasing interest in climate risks and ESG investing, fund managers ought to offer products that “cater to investors with different ESG tastes,” said Taylor. Many asset managers already offer green funds, but few offer the opposite – brown funds – for those who don’t care about ESG, he added. “Our theory tells us that there is a demand for those products. In fact, our theory tells us that roughly half of investors should be buying that brown product, not the green product.”
Fund managers should also communicate to their clients that they expect green assets to underperform brown assets in the future, even if past data does not support that view. He noted that in the last five years, green products have seen unexpected increases in demand, but that may not continue in the future necessarily.