The recent consequences of climate change, driven by increasing negative environmental externalities such as carbon emissions, waste and others, have underscored the importance for regulators, financial markets, and society to address these issues proactively to avoid severe repercussions. It is estimated that achieving net-zero commitments by both the private and public sectors will require an annual investment of $9.1 trillion, amounting to $270 trillion by 2050. While financial markets acknowledge the impact of environmental externalities, it remains unclear whether these markets adequately price in the risks associated with these externalities when providing external capital to firms. My current research investigates whether there is a risk premium for environmental externalities and if there is a premium for securities issued to mitigate these externalities.
Correlation Between Emissions and Financial Performance
Bolton and Kacperczyk (2021) find significant correlations between emissions and firms’ financial performance, including stock returns and profitability. However, studies often use unscaled emissions rather than emissions intensity (emissions relative to revenue) and assume the accuracy of vendor-estimated emissions, which may differ from firm-disclosed figures. Aswani, Raghunandan, and Rajgopal (2023) argue that total emissions are useful for assessing economy-wide risk, but emissions intensity is better for evaluating individual firms. Total emissions mostly reflect production volume, meaning any correlation with stock returns likely indicates firm productivity rather than carbon risk.
Importance of Emissions Intensity and Data Reliability
Emissions intensity, measuring emissions relative to revenue, is a better indicator of a firm’s environmental performance and avoids size bias. The study raises concerns over vendor-estimated emissions, which often differ from firm-disclosed data. This discrepancy suggests that previous correlations between emissions and stock returns may be driven by differences between estimated and actual data. The authors find no link between firms’ actual carbon emissions and stock returns, suggesting no carbon risk premium exists. However, an increase in carbon pricing could change this, as emissions relative to sales would become costlier, warranting further research.
Evaluating Green Securities and Their Impact
Similar to earlier studies on carbon emissions and conventional securities, Aswani and Rajgopal (2024) explore the premium for green securities, like green bonds, and whether they help firms address environmental externalities. Green bonds have become a major asset class, with sales reaching record levels in recent years. Despite growing investor demand, skeptics question their environmental effectiveness.
Past literature suggests socially conscious investors accept lower yields on green securities for societal benefits (Baker et al., 2018; Flammer, 2021). However, others argue green bonds should offer higher yields due to the higher costs associated with third-party validation and the possibility that green investments do not generate positive net present value (NPV) ((Larcker and Watts, 2020).
A key question is whether green bonds lead to positive environmental outcomes. Signaling theory suggests issuing green bonds indicates a commitment to sustainability, and Flammer (2021) finds that green bond issuers reduce emissions over time. However, critics argue that penalties for failing to meet green pledges are low, leading some issuers to neglect their environmental commitments.
The Sustainability Gatekeeper Hypothesis
We propose the ‘sustainability gatekeeper’ hypothesis, where the bond market trusts the financial sector to screen out “brown” issuers when deploying funds raised via green bonds. Financial firms do not directly emit pollutants, making their green bonds more credible and associated with positive stock market responses and greenium in secondary bond markets.
Using green bonds issued from 2013 to 2022, we find an average stock price increase of 0.274% upon announcement, with a more significant 0.330% rise for financial sector firms. In contrast, green bond announcements by polluting sectors show no statistically significant stock price reaction. This suggests that financial firms, rather than the green bonds themselves, drive positive market reactions. Comparing market responses to green versus conventional bonds supports this hypothesis, with green bond announcements producing stronger reactions, particularly for financial sector firms.
Our analysis of secondary bond markets, where impact and use of proceeds reports become available, shows that green bonds trade at an average greenium of 5.7 basis points over one monp, primarily driven by the financial sector, which enjoys an 8.3 bps greenium. Green bonds from polluting sectors, however, yield higher rates, indicating higher perceived risk and lower investor confidence. Interestingly, differences in illiquidity between green and conventional bonds explain greenium discrepancies, with these differences decreasing over time. Similarly, the positive stock reactions to green bonds versus conventional bonds have diminished.
We also examine who issues green bonds and whether they lead to positive environmental outcomes. Firms with higher environmental risk, as measured by MSCI scores, are more likely to issue green bonds, potentially signaling a commitment to reduce their environmental footprint. Flammer (2021) shows that green bond issuers reduce carbon emissions in the year after issuance. However, when examining emissions over a longer period, the reductions do not persist after three years, even when focusing on self-disclosed emissions rather than vendor estimates. This raises doubts about the long-term effectiveness of green bonds in reducing emissions.
Conclusions
These papers explore whether there are risk premiums for negative externalities (like carbon emissions) in conventional securities and premiums for green securities. The first paper argues that negative externalities are intrinsic to firm operations and can only be eliminated through significant business model changes, which take time. Without these transitions, investors should focus on emissions intensity rather than total emissions to assess risk. We find no correlation between carbon intensity and stock returns, particularly in a market where carbon prices are insufficiently high to pose a risk. The limited disclosure of emissions data complicates this further, as most data is vendor-estimated.
The second paper shows that green bonds primarily benefit the financial sector, which acts as a gatekeeper for sustainable capital. Financial firms are perceived more favorably in the market, likely due to their ability to channel funds to sustainable projects without having significant negative environmental externalities themselves. Past research showing positive stock reactions to green bond issuance is mostly limited to financial firms, while green bonds from higher-emitting issuers show little reduction in emissions post-issuance. This underscores the complex dynamics between financial markets and environmental stewardship, with the environmental benefits of green bonds being less clear-cut than anticipated.