ESG investment returns face a slowdown

Over the past decade, environmentally friendly stocks have tended to outperform others, backing the case by investors and investment managers for using environmental, social and governance (ESG) criteria. But our research shows that such past performance is the opposite of what to expect in the future.

Investors should expect green assets to underperform environmentally unfriendly, or “brown”, assets for two reasons. First, many investors choose to hold a portfolio in line with their values, by allocating more to green assets or divesting their brown holdings. This relatively higher demand means green assets command higher prices, thereby implying lower expected future returns.

Second, green assets are a climate hedge, performing better than brown in the face of bad news about climate change. Investors value this hedging ability, resulting in higher prices and lower expected returns for green assets relative to brown.

Lower expected returns on green assets show up in the data. A useful case study comes from Germany, whose government began issuing green bonds in 2020. Germany paired each green bond with a non-green “twin” bond with identical cash flows, offering a clean comparison. The green bonds consistently had lower yields to maturity than their twins, indicating lower expected returns — and higher prices — for the greener asset.

A similar pattern appears in US stocks. To measure their expected returns, we compute the rate of return that equates a stock’s current price to the discounted stream of its future payouts. These implied costs of capital were consistently lower for green stocks than brown stocks over the previous decade, with greenness measured using MSCI environmental ratings. By this measure, investors expected green stocks to underperform brown.

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We also look at what drove realised returns, recognising that what was expected can differ from what happened. Driven by adverse news about climate change, green stocks outperformed over the previous decade because their prices rose unexpectedly relative to brown ones.

During months in which major news outlets ran unexpectedly negative climate news, green stocks significantly outperformed brown ones. If we remove those climate-news shocks along with unanticipated earnings news, we find that green stocks would actually have underperformed brown stocks.

This result, again, points to lower expected returns on greener assets. Green stocks overcame their lower expected returns to produce higher realised returns, thanks to shocks, or “luck”, in the form of unforeseen bad climate news.

Why was bad news about the climate good news for green stock returns relative to brown? Heightened climate concerns are likely to have increased investors’ desire to hold green assets, directly pushing up their prices. Climate concerns also probably raised the anticipated profits of green companies and lowered those of brown companies. For instance, expected sales of electric vehicles may have increased, along with the likelihood of carbon taxes and regulations.

Our study also offers new insights into value and growth investing. For nearly a century, value stocks (with low market prices relative to accounting book value) on average outperformed growth stocks (with high market prices relative to book value). During the past decade, however, value stocks sharply underperformed growth stocks, to an extent previously not experienced.

This historic underperformance can largely be attributed to the outperformance of green stocks versus brown. Once we control for that, most of value stocks’ underperformance disappears. The simple reason is that value stocks tend to be brown on average, while growth stocks tend to be green.

Of course, we expect climate change to be a large and growing problem, but an efficient market already bakes those expectations into prices today

What do these findings mean for investors, companies, and the environment? First, investors should not expect the high returns seen on green assets over the past decade to continue. Like other shocks, the climate shocks that caused past green outperformance cannot be expected to continue.

Of course, we expect climate change to be a large and growing problem, but an efficient market already bakes those expectations into prices today. For green assets to outperform in the future, news — climate or otherwise — must be worse than currently expected. That may well happen, but we cannot expect it, otherwise it would not be news.

Second, investors should not expect value stocks’ recent underperformance to continue. This underperformance was largely driven by the same shocks that made green stocks outperform brown.

Finally, some good news for the environment. Since expected return and cost of capital are the same concept, our findings imply that greener assets have a lower cost of capital, all else being equal. That is, companies should use a lower cost of capital when evaluating potential green investments compared with brown ones. The environment thus benefits as capital shifts from brown to green activities and companies are incentivised to become greener. 

Lubos Pastor is the Charles P McQuaid professor of finance at the University of Chicago Booth School of Business. Robert F Stambaugh is the Miller Anderson & Sherrerd professor of finance at the Wharton School of the University of Pennsylvania. Lucian A Taylor is the John B Neff professor in finance at Wharton.

This article is based on their paper Dissecting Green Returns, winner of the 2022 Moskowitz prize, awarded for research in sustainable finance (2022, Journal of Financial Economics).