BEPP Set 3: Climate Risk in Equity Markets

Green glow

Investors get non-financial utility from holding green assets, so they pay more for them.

Green glow effect on prices and returns

Green assets have higher prices and lower expected returns; brown assets have lower prices and higher expected returns.

Class experiment takeaway

Investors bid about $0.80 more per $1 of charity donation, so they value non-cash-flow characteristics, not just cash flows.

Two reasons green stocks have lower expected returns

(1) Lower climate risk exposure (lower climate beta); (2) green glow bids up their prices.

Brownium

The risk premium investors demand for holding carbon-intensive assets; shows up as higher expected returns or yields.

Greenium

The premium investors pay for green assets; shows up as lower yields or returns.

Expected vs. realized returns

CAPM predicts expected returns; realized returns also include surprises (news about profits, policy, or investor preferences).

Why green stocks can outperform brown even if climate risk is priced

Unexpected news, e.g., stricter climate policy or rising green demand, lifts green prices and hurts brown ones. Higher green realized returns don't prove climate isn't priced.

Effect of surprise strict climate regulation

Brown stocks fall, green stocks rise.

Effect of climate policy rollback

Brown stocks rise, green stocks fall.

Evidence that brown stocks earned higher returns

Firms with higher total emissions and emissions growth earned higher returns, consistent with a carbon risk premium.

Alternative explanation for the brown premium

High-emission firms beat analyst earnings forecasts; surprise profits, not just risk compensation, explain part of the premium.

Emissions level vs. intensity

Higher returns are linked to total emissions and emissions growth, not emissions intensity (emissions per unit of sales).

Scope 1 emissions

Direct emissions from the firm's own operations.

Scope 2 emissions

Emissions from the energy the firm buys.

Scope 3 emissions

Upstream (suppliers) and downstream (customers using the product, e.g., driving a car) value chain emissions; often the largest share for many firms.

Why scope 3 matters financially

It captures transition risk passed through the supply chain; e.g., a carbon tax on a supplier raises the firm's costs.

ESG ratings caveat

Different rating providers classify firms differently, so green vs. brown results can flip depending on which ratings you use.

How divestment is supposed to work

Selling lowers the stock price and raises the firm's cost of capital, discouraging brown investment.

Why divestment has little impact

Few investors divest and brown stocks are highly correlated with the market, so other investors absorb them easily; the cost of capital barely moves.

Divest or engage conclusion

Engagement (voting, lobbying management) is likely more effective than divestment at changing firm behavior.