The Price Investors Paid for Owning Bonds of “Brown” Companies

New research shows that bonds from carbon-emitting (“brown”) companies have underperformed those of green companies during last 13 years, but, contrary to theory, they are riskier. Indeed, brown bonds may outperform in the future, as the temporary effect from increased investor demand subsides.

Traditional asset pricing theory predicts that investors should demand higher expected returns for holding securities issued by carbon-intensive firms to compensate investors for their higher exposure to carbon risks (the “carbon risk premium” hypothesis). However, the empirical evidence on equities is somewhat ambiguous, with some studies finding a carbon premium and others not. Investor preferences lead to different short- and long-term impacts on asset prices and returns. Firms with high sustainable investing scores earn rising portfolio weights, 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 will earn higher future expected returns.

In other words, there is an ambiguous relationship between carbon risk and returns in the short term.

As Maximilian Görgen, Andrea Jacob, Martin Nerlinger, Ryan Riordan, Martin Rohleder and Marco Wilkens, authors of the 2020 study, “Carbon Risk,” noted: “Over time as the markets develop a better understanding of carbon risk and the unexpected component falls relative to the expected component, we should expect a positive relationship between returns and carbon risk.” Without this understanding, investors can misinterpret findings that appear to show the lack of a carbon premium. There was an ex-ante carbon premium, but the ex-post results showed a negative premium because of cash flows raising valuations of green companies. Given the continued trend in sustainable investing, it will be a while before we reach a new equilibrium. In the meantime, despite investors requiring a risk premium for carbon risks, green stocks can outperform brown ones.