Debate swirls around whether environmentally friendly companies outperform the wider universe of firms. A study by Stanford and Yonsei university economists offers compelling evidence that they do.
The researchers, Stanford’s Soh Young In and Ashby Monk, and Yonsei University’s Ki Young Park, found that from 2005 to 2015, the share price gains of the most carbon-efficient companies beat the prices of less-efficient firms. Once the market recovered from the 2008-2009 financial crisis, the so-called Efficient-Minus-Inefficient (EMI) portfolio performance accelerated.
After 2010 the “investment strategy of long carbon-efficient firms and short carbon-inefficient firms” was 3.5% to 5.4% better per year than than that of firms that ignored carbon efficiency. A portfolio of carbon outperformers achieved ESG alpha, or peer-beating returns.
Updated in April following its original 2017 publication, the “Is ‘Being Green’ Rewarded” research put 736 large U.S. public corporations across 12 sectors into three portfolios. One contained each sector’s carbon laggards, a second held more middling performers and the third, dubbed Carbon Efficient-Minus-Inefficient, had the leading firms in terms of carbon efficiency based on as judged by a complex mix of factors.
“A strategy of ‘long carbon-efficient firms and short carbon-inefficient firms’ earns alpha due to the outperformance of carbon-efficient firms, not from the underperformance of carbon-inefficient firms,” the study noted.
New white papers and smaller pieces by investment bank analysts on ESG performance show that well-rated ESG companies, which include those with positive carbon ratings, outperform poorly rated peers. This has been true over different periods and also, as I wrote recently, during times of market volatility. The Stanford-Yonsei study puts an exclamation mark on this point.
“There’s a place in a portfolio for these types of [ESG] funds, but environmental and socially conscious investors should examine their own risk/reward profile and consider whether they could accept lower returns with ESG funds over the long term,” wrote the study’s author, Wayne Winegarden, PRI senior fellow in business and economics.
It’s worth noting that Winegarden recently submitted testimony to the SEC supporting its move to restrict ESG’s influence over pension fund investments in favor of a stricter fiduciary approach.
The Maturity Question Again
That ESG metrics have only been around just over a decade is not in doubt. Further studies will be needed. The authors of the Stanford-Yonsei report don’t expect the issue to be settled anytime soon.
“It has been particularly difficult to convince investors of the financial legitimacy of climate and environmental risks,” they wrote, “because traditional finance theory instructs us that anything that arbitrarily limits the investable universe of companies and opportunities will reduce risk-adjusted returns.”
But the overperformance of the carbon efficient EMI portfolio over six years is powerful evidence. In the end, numbers like that will matter most to investors.