Is 'Being Green' Rewarded in the Market?: An Empirical Investigation of Decarbonization and Stock Returns

Abstract

Climate change could have potentially devastating effects on societies and economies globally, and climate finance to combat the challenges related to it demands large-scale capital. However, this form of investment has been hampered by the unclear relationship between corporate environmental performance and financial performance. To address this, this study empirically investigates the risk-return relationship of low-carbon investment and characteristics of carbon-efficient firms. Based on 74,486 observations of 736 US firms from January 2005 to December 2015, we construct a carbon efficient-minus-inefficient (EMI) portfolio by carbon efficiency, defined as revenue-adjusted greenhouse gas (GHG) emissions at the firm-level. Our EMI portfolio generates positive abnormal returns since 2010 and an investment strategy of "long carbon-efficient firms and short carbon-inefficient firms" would earn abnormal returns of 3.5-5.4% per year. The only exception is found in small firms. We find that these carbon-efficient firms tend to be "good firms'' in terms of financial characteristics and corporate governance. Our findings are not driven by a small set of industries, variations in oil price, or changing preferences of bond investors caused by the low-interest-rate regime, starting with the 2008 financial crisis.

Keywords: Environmental Social and Governance (ESG); Socially Responsible Investment (SRI); Sustainable Finance; Low-Carbon Investment; Multi-Factor Asset Pricing Model; Carbon Efficient-Minus-Inefficient (EMI) Portfolio

JEL Classification: G12, G30, P18