This summer, the 22nd of July marked the hottest day recorded on Earth (Copernicus Climate Change Service, 2024). In fact, the temperature of the Earth’s surface has since the 1880s increased by 1.1 degrees C, on average. Such rate of warming is at least ten times faster than any observed over the past 65 million years and is expected to increase the frequency and severity of extreme weather events (Woetzel et al., 2020). Climate risk embodies the possible influence that changes in the climate can have on the financial performance of firms. This risk can be separated into two categories (EarthScan, 2024).
Firstly, physical climate risk refers to the material losses that occur as the result of extreme weather events such as floods, wildfires, droughts, and others. This risk is unevenly distributed, where some regions are more severely affected than others. Although, over time, areas that are not at risk now can become exposed as well. Physical climate risk can manifest directly through impairment costs or a decline in the efficiency and output of production. On the other hand, it can also have indirect effects such as disruptions in supply and demand. Both ways impact investors through a change in earnings or a rise in default risk (Sustainalytics, 2023).
Secondly, transition risk represents the risk associated with moving away from fossil fuels and other activities that emit greenhouse gases. All over the world, policymakers emphasize the importance of decarbonization. However, reducing companies’ carbon footprint has proven to be costly and as such exposed to transition risk. Organizations that fail to make this transition are left exposed to regulatory penalties or a loss of market share. Both transition and physical risk are closely linked as the intensification of one amplifies the other, creating a compounding threat (EarthScan, 2024).
Therefore, it is far from surprising that sustainable investing is growing in popularity among investors. According to a survey by the Morgan Stanley Institute for Sustainable Investing (2024), 77% of individual investors worldwide indicate they are keen on investing in companies that pursue market-rate financial returns alongside positive social and environmental impact. Furthermore, over half of these investors are planning to increase their allocation to sustainable investments within the coming year (Morgan Stanley Institute for Sustainable Investing, 2024). This represents a broader shift in the mindset of investors who see green investments not only as ethical but also as a smart investment strategy (Cheung, 2023).
In 2023, sustainable funds reached a median return of 6.9% compared to the 3.8% of traditional funds, representing a rebound after a relative underperformance in 2022. Sustainable investments which lean more towards growth stocks to prioritise long-term focus, suffered as a result of volatile market conditions, which favoured value stocks. Therefore, growth stocks relatively underperformed. In 2023, macroeconomic conditions stabilised and the differentiation between value and growth stocks became less prominent (Morgan Stanley Institute for Sustainable Investing, 2023).
The relationship between equity returns and carbon emissions has been examined in several studies, the results of which yielded diverging conclusions. For instance, Pástor et al. (2022) credit the increase in environmental awareness for the superior performance of green stocks. Additionally, they find that green stocks outperform brown stocks when there is negative climate change news, which supports the idea that green stocks serve as a hedge against climate change risk. However, they also caution that recent gains in green stocks are not an indication of outperformance going forward.
Another study by Bauer et al. (2023) found that from 2010 to 2021, green stocks consistently outperformed brown stocks in the U.S. and also showed higher risk-adjusted returns (higher Sharpe ratios) compared to brown stocks. However, brown stocks performed better than green in the first half of 2022 possibly due to the unexpected demand in energy and defence sectors amid the Russia-Ukraine war.
On the other hand, Bolton and Kacperczyk (2021) analysed a sample of US firms from 2005 to 2017 and found that emissions have a significant and positive effect on stock returns. This is consistent with the carbon premium hypothesis, where investors require higher returns for firms with high emissions due to the increased risk. In an additional study, Bolton and Kacperczyk (2023) also discovered evidence that firms with higher total emissions and higher emission growth rates have higher returns. This suggests that high-polluting firms are exposed to greater risk from the transition from fossil fuels to renewable energy sources.
All in all, the academic literature has yet to reach a unified conclusion, and this sheds light on the complexity of this issue. Over the next decade, it is vital that companies and investors cooperate and recognize the importance of making the economy more sustainable and equitable. It will not be an easy task and it is vital that there are effective ways to finance this transition. To achieve the key 2030 interim targets, firms will need to reshape their corporate practices and business models. Additionally, long-term investors will have to determine how to allocate their capital to meet global climate objectives (Alsford, 2023). Furthermore, to fully capitalize on the momentum of sustainable investing, investors should familiarize themselves with sustainability measures and ESG criteria. Looking ahead, the incorporation of ESG considerations into investment portfolios is set to become the norm as opposed to an exception. Investors should adapt to this new landscape where sustainability is as crucial as profitability (Cory-Wright, 2024).
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