What a Company’s Emissions Tell Us about Its Expected Returns
Climate scientists have identified greenhouse gas (GHG) emissions as the largest contributor to global climate change.1 As a result, many investors are looking to reduce their emissions exposure through their portfolios and wondering if doing so would affect their expected performance. A new research paper from Dimensional delves into this subject by examining the relation between firm-level emissions and expected returns.
Before venturing into the empirical analysis, it is helpful to consider the theoretical channels through which a company’s emissions characteristics may impact its expected stock or bond returns. Valuation theory tells us that current market prices reflect aggregate investor expectations about future cash flows and the discount rates they apply to those cash flows. The discount rates are investors’ expected rates of return.
It is reasonable to expect that a firm’s environmental profile could impact its future cash flows and the discount rate, due to risks, opportunities, and preferences associated with sustainability considerations. For example, if a company’s business is highly emissions intensive, market participants considering the economic impact of the company’s emissions may adjust their future cash flow expectations and discount rate. These considerations are reflected in the price they are willing to pay today for the company’s stock or bond. Therefore, from an investment perspective, it is important to understand whether emissions contain additional information about expected returns beyond what can be extracted from current market prices.
Our study of the relation between emissions and expected returns covers the US, developed ex US, and emerging markets stocks as well as US corporate bonds from 2009 to 2018. We examine firm-level emissions profiles through three metrics: emission intensity, emission level, and change in emission level.
We do not find evidence of a reliable link between a firm’s emissions profile and future stock returns. Over the sample period, there are mixed results about the relation between stock performance and emission intensity, emission level, and change in emission level. When controlling for the known drivers of expected returns (size, value, and profitability), there is generally little evidence that a firm’s emissions profile provides additional information about expected stock returns.
Turning to fixed income, the data similarly do not show a reliable relation between emission profiles and corporate bond returns. Much like in the equity investigation, this finding also holds true when we control for well-known drivers of expected bond returns.
The paper also examines the potential impact of emissions variables on future profitability. Research has shown that profitability is persistent and current profitability is a reliable proxy for future profitability. Our results suggest that, after controlling for current profitability, emission intensity, emission level, and change in emission level lose their explanatory power for future profitability (if any). In other words, there is no incremental informational content in these emission metrics about future profitability above and beyond what is contained in current profitability.
The lack of a strong relation between firm-level emission metrics and security returns may be because of data limitations. The sample period is relatively short, and emissions reporting is voluntary and not standardized. On the other hand, our results are consistent with the belief that market prices provide the most complete and up-to-date prediction of future returns, including if and how emissions may impact returns. Therefore, an investment process that considers current market prices likely captures information about a company’s environmental risks and opportunities. That means investors may incorporate sustainability considerations into their broadly diversified, systematic investing framework without compromising sound investment principles.
- 1See, for instance, the Intergovernmental Panel on Climate Change’s Climate Change 2014: Synthesis Report.
Discount rate: Also known as the “required rate of return,” this is the expected return investors demand for holding a stock.
Size premium: The return difference between small market capitalization stocks and large market capitalization stocks.
Value premium: The return difference between stocks with low relative prices (value) and stocks with high relative prices (growth).
Profitability premium: The return difference between stocks of companies with high profitability over those with low profitability.
Future cash flows: The income a company produces for investors in the future.
Emission level: Measured as the sum of direct (Scope 1) and indirect (Scope 2) GHG emissions in metric tons of carbon dioxide equivalents. For definitions of different emissions scopes, see https://www.epa.gov/greeningepa/greenhouse-gases-epa
Emission intensity: Emission level divided by sales in USD million.
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