Some have suggested there could be a return premium to lowering the carbon intensity of a portfolio.
By constructing low carbon strategies called decarbonization factors, which go long on lower carbon investments and short on higher ones, it’s certainly possible, according to a paper authored by professor George Serafeim from the Harvard Business School along with State Street Associates’ head of environmental, social and governance research, Bridget Realmuto LaPerla, senior vice-president David Turkington, managing director Alexander Cheema-Fox and quantitative researcher Hui Wang.
Different low carbon investment strategies have varying effects with regard to returns, the paper said, noting an overall link between decarbonization and performance.
“We consider several portfolio formation strategies and find strategies that lowered carbon emissions more aggressively performed better,” the paper said.
The paper compared six portfolio construction strategies, with some strategies delineating carbon intensity across sectors, some getting more granular by categorizing individual industries within sectors and some getting even more specific by defining the carbon intensity of individual firms. “We create decarbonization factors for each strategy, buying low carbon intensity sectors, industries, or firms and selling high carbon intensity equivalents.”
Looking at the period of 2009 to 2018, and investing separately in both the U.S. and Europe, the models appear to provide approximately two per cent alpha in aggregate annually.
The alpha is more pronounced when investing in Europe, which isn’t surprising as the paper noted the continent has responded more aggressively to the challenge of lowering carbon emissions.
In addition, the research found a positive relationship between flows into decarbonization factors and their returns. “This suggests that demand for stocks with low carbon intensity has pricing effects,” the paper said. “This could be because flows of institutional money carry information about changes in the anticipated fundamentals. An alternative explanation is that uninformed demand shocks cause prices to deviate from fundamentals. We do not find evidence of price reversal manifesting as a negative relationship between flows and future returns, which would be consistent with a noise trader story.”
Indeed, when flows into decarbonization investments are positive, their related factors perform substantially better, the paper said. “Buying the factor when flows are positive, while selling the factor when flows are negative, yields even larger and more significant alphas between 1.48 per cent and 4.43 per cent in the U.S. and 2.5 per cent and 8.51 per cent in Europe.”