Polluting Firms Earn Higher Returns

Environmental protection awareness has surged over the past several decades, along with a comparable surge in academic research, on the impact of environmental, social, and governance investment strategies on investor returns.

The Pollution Premium

Po-Hsuan Hsu, Kai Li, and Chi-Yang Tsou contributed to the ESG literature with their February 2023 study “The Pollution Premium,” in which they constructed empirical proxies for firm-level pollutants and then examined the cross-sectional variation in the relation between stock returns and industrial pollution. Their measure of “emission intensity” used pollution data from the Toxic Release Inventory database.

Specifically, for each year from 1991 to 2016, they captured a firm’s toxic emissions by summing emissions of all types of chemicals across all plants listed in the TRI database maintained by the U.S. Environmental Protection Agency. They then calculated a firm’s emission intensity as its ratio of toxic emissions to total assets.

They noted, “Firms with higher emission intensity are associated with a higher frequency or probability of being involved in environment-related lawsuits.”

They also proposed and modeled a new systematic risk related to environmental policy uncertainty, using the growth of environmental litigation penalties to measure regime change risk. The authors explained, “The basic intuition is that high-emission firms are more exposed to risks of environmental policy regime change and therefore require higher expected returns as compensation.”

Following is a summary of their key findings:

• Emission intensity significantly decreased with firm size and significantly increased with asset tangibility—other firm characteristics could not predict emissions.
• A long-short portfolio constructed from firms with high versus low toxic emission intensity within a given industry generated an average return of 4.42% per year (which remained significant after controlling for risk factors), and the quintile portfolio sorts from low to high had annualized excess returns of 6.90%, 9.68%, 9.08%, 9.11%, and 11.32%, respectively. Results were statistically significant at conventional levels.
• The Sharpe ratios of the quintile portfolios were 0.45, 0.57, 0.58, 0.55, and 0.69, respectively, and that of the high-minus-low portfolio was 0.46 (comparable to the Sharpe ratio of the equity risk premium).
• The pollution premium could not be explained by existing systematic risks (capital asset pricing model and Fama-French five-factor model), investors’ preferences, market sentiment, political connections, corporate governance, financial constraints, macroeconomic uncertainty, or technological obsolescence.
• In their model, regime change risk was significantly negatively priced—investors demanded a risk premium for exposure to changes in government environmental policies.

Hsu, Li, and Tsou’s findings led them to conclude, “Firm-level emissions help explain subsequent stock returns.” They added that their results “do not rule out the possibility that the pollution premium may be driven by a subset of high-pollution firms that significantly reduce their emissions in the future, leading subsequent stock prices to rise [as their risk is reduced].”

Their findings are consistent with those of Erika Berle, Wangwei He, and Bernt Ødegaard, authors of the October 2023 study “The Expected Returns of ESG Excluded Stocks. Shocks to Firms Costs of Capital? Evidence From the World’s Largest Fund,” in which they analyzed the consequences of widespread ESG-based portfolio exclusions on the expected returns of firms subject to exclusion. Over the period from 2005 to 2021, they found that, just as economic theory predicts, exclusion portfolios (low ESG-scoring firms) had significantly superior performance (alpha) relative to a Fama-French five-factor model. For example, the equal-weighted (value-weighted) portfolio of all excluded stocks had a statistically significant annual alpha of 5.2% (6.9%). Alphas were significant at the 1% confidence level. They also found that the exclusion portfolio had lower systematic risk than the market: Market beta was below 1. Their findings led them to conclude, “Our results indicate that low-quality ESG firms have a return premium.”

Economy Theory

As Sam Adams and I explained in Your Essential Guide to Sustainable Investing, while sustainable investing continues to gain in popularity, economic theory suggests that if a large enough proportion of investors choose to favor companies with high sustainability ratings (green businesses) and avoid those with low sustainability ratings (brown or “sin” businesses), the favored companies’ share prices will be elevated and the excluded shares will be depressed. In equilibrium, the screening out of certain assets based on investors’ preferences/tastes should lead to a return premium on the screened assets.

The result is that the favored companies will have a lower cost of capital because they will trade at a higher price/earnings ratio. The flip side of a lower cost of capital is a lower expected return to the providers of that capital (shareholders). In conjunction with that idea, sin companies will have a higher cost of capital because they will trade at a lower P/E ratio, the flip side of which is a higher expected return to the providers of that capital. The hypothesis is that higher expected returns (a premium above the market’s required return) are required as compensation for the emotional cost of exposure to offensive companies. On the other hand, investors in companies with higher sustainability ratings are willing to accept lower returns as the cost of expressing their values.

There is also a risk-based hypothesis for the sin premium. It is logical to hypothesize that companies neglecting to manage their ESG exposures could be subject to greater risk—that is, a wider range of potential outcomes than their more ESG-focused counterparts. The argument is that companies with high sustainability scores have better risk management and compliance standards. Stronger controls lead to fewer extreme events such as environmental disasters, fraud, corruption, and litigation (and their negative consequences). The result is a reduction in tail risk in high-scoring firms relative to the lowest-scoring firms. The greater tail risk creates the sin premium.

In addition, sustainable investors sacrifice some of the benefits of diversification relative to a broad-based market index fund because their investments are limited to the universe of stocks that meet a sustainable investing screening process. Intuitively, less diversified portfolios are less efficient because exclusions reduce the feasible set of investment portfolios (ESG investors hold less diversified portfolios), worsening the risk/reward trade-off.

Our book takes a deep dive into the empirical research findings, reviewing dozens of papers that demonstrate support for both the preferential/taste and risk-based theoretical explanations for the sin premium. The book also discusses in depth the impact on returns of the dramatic increase in cash flows from sustainable investors. These cash flows create conflicting forces, as investor preferences lead to different short- and long-term impacts on asset prices and returns. Firms with high sustainability scores earn rising portfolio weightings, leading to short-term capital gains for their stocks—realized returns rise temporarily. However, the long-term effect is that higher valuations reduce expected long-term returns. The result can be an increase in green asset returns even though brown assets earn higher expected returns. In other words, there can be an ambiguous relationship between carbon risk and returns in the short term.

Investor Takeaways

While the empirical research has found that excluded stocks have provided excess returns, those returns are accompanied by the greater risks of these companies. As discussed in Your Essential Guide to Sustainable Investing, low-scoring ESG stocks have greater risks, including potential legislation leading to stranded assets, potential consumer boycotts, frauds stemming from poor risk controls and poor governance, and human rights and environmental scandals. The result is that they have less crash risk. In other words, those higher returns are not free lunches but, at least partially, are compensation for greater risks.

The views expressed here are the author’s. Larry Swedroe is head of financial and economic research for Buckingham Wealth Partners, collectively Buckingham Strategic Wealth, LLC and Buckingham Strategic Partners, LLC.

For information and educational purposes only and should not be construed as specific investment, accounting, legal, or tax advice. Certain information is based on third party data and may become outdated or otherwise superseded without notice. Third party information is deemed to be reliable, but its accuracy and completeness cannot be guaranteed. Individuals should speak with a qualified financial professional based on their circumstances. The opinions expressed here are their own and may not accurately reflect those of Buckingham Strategic Wealth, LLC or Buckingham Strategic Partners, LLC, collectively Buckingham Wealth Partners. Neither the Securities and Exchange Commission (SEC) nor any other federal or state agency have approved, determined the accuracy, or confirmed the adequacy of this article. LSR-23-607