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 investment experience. 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 aggregate investor preferences shift in favor of companies with lower emissions, this can increase the prices and decrease the expected returns of stocks and bonds issued by these companies.
Our study of the relation between emissions and expected returns covers 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. Turning to fixed income, the data similarly do not show a reliable relation between emissions profiles and expected corporate bond returns.
The paper also examines the potential impact of emissions variables on future profitability. Research has shown that profitability is persistent and that 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 implies that the impact of sustainability-related changes to aggregate investor demand may have been small over the time period we study. Data limitations also make it challenging to detect any potential relation empirically: the sample period is relatively short, security returns are volatile, and emissions reporting is voluntary and not standardized. On the other hand, to the extent that current or future shifts in investors’ tastes and preferences impact security prices and expected returns, we expect an investment approach built on the valuation framework to capture such impacts and be able to identify differences in expected returns through market prices and proxies for expected future cash flows.