Theoretical model explains why green assets will underperform – but investors won't be unhappy about it
While it’s perfectly possible for green investments to outperform in the long term, ESG-focused investors should expect lower returns than the broader stock market on average – and still be ok with it.
As explained on Knowledge@Wharton, finance professors Lubos Pastor at the University of Chicago, and Robert F. Stambaugh and Luke Taylor at the Wharton School of the University of Pennsylvania recently conducted a study forming a theoretical framework to help investors and researchers interpret ESG investing data.
“In equilibrium, green assets have low expected returns because investors enjoy holding them and because green assets hedge climate risk,” the paper said.
According to the paper, green assets that are priced higher today should have lower expected returns in the future. Given that average expectation of underperformance, green assets should fall squarely into the category of “bad” investments. As well, green assets act as a hedge against climate risk, which theoretically means they have lower return potential.
However, it’s still possible for green assets to outperform depending on property the researchers called the “ESG factor.” As Taylor explained, consumers might become more interested in buying products or services from green companies, or investors might become more interested in holding green assets.
“If those changes come as surprises, then green assets can outperform,” he told Knowledge@Wharton. Such unanticipated turns and their impacts, he added, are not based on empirical knowledge of equity returns but on the study’s model.
That model also showed ESG investing has a twofold social impact, Taylor said, accelerating green activities in the broader economy while paring brown activities. This happens because ESG investing lowers the cost of capital for green companies, which allows those firms to expand. At the same time, it creates an incentive for other companies to switch from brown to green ways of operating.
And while an ESG portfolio should underperform the market on average, the paper projects that those invested in it won’t be disappointed.