Sustainable investing has grown substantially in recent years, demonstrating that investor demand can be driven by nonfinancial issues such as environmental (E), social (S), and governance (G) characteristics. A full list of our posts on ESG can be found here. The demand from investors who have a preference for investing based on their values could impact valuations and thus expected returns. Economic theory suggests that if a large enough proportion of investors choose to favor companies with high sustainability ratings (choosing conscience over returns) and avoid those with low sustainability ratings (“sin” businesses), the favored company’s share prices will be elevated, and the sin stock shares will be depressed. Specifically, in equilibrium, the screening out of certain assets based on investors’ taste should lead to a return premium on the screened assets.
The result is that the favored companies will have a lower cost of capital because they will trade at a higher price-to-earnings (P/E) ratio. The flip side of a lower cost of capital is a lower expected return to the providers of that capital (shareholders). And the sin companies will have a higher cost of capital because they will trade at a lower P/E ratio. The flip side of a company’s higher cost of capital is a higher expected return to the providers of that capital. The hypothesis is that the higher expected returns (a premium above the market’s required return) are required as compensation for the emotional cost of exposure to offensive companies. On the other hand, investors in companies with higher sustainability ratings are willing to accept the lower returns as the “cost” of expressing their values.
There is also a risk-based hypothesis for the sin premium. It is logical to hypothesize that companies neglecting to manage their ESG exposures could be subject to greater risk (that is, a wider range of potential outcomes) than their more ESG-focused counterparts. The hypothesis is that companies with high sustainability scores have better risk management and better compliance standards. These stronger controls lead to fewer extreme events such as environmental disasters, fraud, corruption, and litigation (and their negative consequences). The result is a reduction in tail risk in high-scoring firms relative to the lowest-scoring firms. The greater tail risk creates the sin premium.
Investor preferences can lead to different short- and long-term impacts on asset prices and returns. Firms with high sustainability scores earn rising portfolio weights, leading to short-term capital gains for their stocks—realized returns rise temporarily due to a positive shock to the discount rate applied to their future earnings. However, the long-term effect is that higher valuations reduce expected long-term returns. The result can be an increase in green asset returns even though brown assets earn higher expected returns—there can be an ambiguous relationship between carbon risk and returns in the short term, creating what could be called the “ESG return puzzle.” The puzzle refers to the phenomenon that, recently, realized stock returns have tended to be positively related to ESG, while expected returns tend to be negatively related to ESG (though over time we should expect a positive relationship between returns and ESG risk). Without this understanding, investors can misinterpret findings that appear to show a lack of a sustainability risk premium.
Olaf Stotz contributes to the sustainable investing literature with his study “Expected and Realized Returns on Stocks with High‑ and Low‑ESG Exposure,” published in the March 2021 issue of the Journal of Asset Management. Stotz analyzed the two channels that impact realized and expected returns: the cash flow channel (do high-scoring ESG firms benefit from unexpected improvements in profitability?) and the discount rate channel (do high-scoring ESG stocks benefit from a falling discount rate?). He used a valuation model (from the study “Toward an Implied Cost of Capital”) and analysts’ earnings forecasts to compute a firm’s implied cost of capital, which is an estimate of the expected return. Using a large sample of U.S. companies from 2008 to 2018, he formed a hedge portfolio that was long in high-ESG stocks and short in low-ESG stocks (an HL portfolio).
Following is a summary of his findings:
- The HL portfolio earned a positive realized return of 2.3 percent per annum. Results were a similar 2.6 percent when adjusted for the Fama-French six-factor (beta, size, value, investment, profitability and momentum) model. Thus, the average returns were not well explained by exposures to common factors. However, it earned a negative expected return of about -0.5 percent per annum.
- There was no evidence that the cash flow channel was able to explain a positive unexpected return of the HL portfolio—in fact, cash flow news tended to make the unexpected return of the HL portfolio even larger (cash flow expectations of the HL portfolio were not revised upward).
- The discount rate channel did provide an explanation for the ESG return puzzle, as the discount rates of the HL portfolio fell over the sample period.
- The impact of discount rate news varied between 2.1 and 3.6 percent and explained to a large extent the unexpected return of the HL portfolio.
- The discount rate channel was explained by investor demand, not by time-varying risk attributes—an increasing share of investors with ESG preferences was positively correlated with a decreasing discount rate of the HL portfolio.
- An increase in the ratio of ESG investors to all investors by 10 percentage points increased prices of ESG companies with a high ESG rating by 9.5 percent relative to very low-ESG companies.
- H stocks are less risky than L stocks.
- Their results were robust to changes in various assumptions in their base case approach.
His findings led Stotz to conclude:
“The empirical results are compatible with the view that some investors have non-financial preferences linked to ESG. This view implies that expected future returns on the HL portfolio will be considerably lower than realized past returns if the demand for ESG stocks does not increase further.”
“Several robustness checks provide evidence that the main conclusions are rather robust.”
Summarizing, Stotz provided direct evidence of why the unexpected return of the HL portfolio was positive. He also provided evidence that the ESG return puzzle can mainly be described by discount rate news, while cash flow news makes the puzzle worse.
For sustainable investors, Stotz’s finding that H stocks have outperformed due to increased demand leading to lower discount rates means that once a new equilibrium (which may take a long time) is reached, ESG assets should deliver returns that are lower than in the past. Stotz noted: “This may disappoint some investors in the long-term if they are not willing to accept lower returns for holding ESG assets.” For corporations, the implication is that a focus on improving their ESG scores will likely lower their cost of capital, giving them an incentive to focus on that issue.
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