This policy brief explores the impact of green investors on stock prices, based on a dynamic equilibrium model. The study reveals that a net zero strategy implemented by green investors would result in a significant drop in the stock prices of the brownest firms and moderate increases for greener firms upon the announcement and during the exclusion phase of a green index. The findings highlight a first-mover advantage for early adopters of decarbonisation strategies.
The role of financial asset owners and managers is widely debated in the fight against climate change. As large institutional investors hold shares in firms with high greenhouse gas emissions, they indirectly contribute to global warming by financing polluting activities. Increasingly, corporate and central banks initiatives have sought to promote net zero investment.
Two primary approaches to promoting green investment are divestment and engagement. Divestment involves investors selling off their shares in the brownest firms, while engagement entails influencing these firms to transition to greener operations through votes at annual general meetings. A key question is whether divestment raises the cost of capital for brown firms, thereby affecting their future business development.
This study uses a dynamic equilibrium model to determine the impact of institutional investors reducing their exposure to the most polluting firms. It considers three categories of investors: active investors who hold a mean-variance efficient portfolio of all stocks, passive investors who hold a value-weighted index of all stocks, and green investors who hold a value-weighted index that progressively excludes brown firms. The exclusion of brown firms occurs sequentially, with the 1% of the most polluting firms excluded every year over ten years, resulting in an overall excluding of the 10% brownest firms.
The model solves for equilibrium analytically, both for the transition phase and the ensuing steady state, building on Buffa, Vayanos and Woolley (2022) and Jiang, Vayanos and Zheng (2022). For a given calibration of the model and decarbonisation trajectory of the green index, we determine the dynamics of equilibrium prices and portfolio holdings.
In the baseline scenario, the population of investors is split between 30% green investors, 50% passive investors, and 20% active investors. These investors’ shares are approximately consistent with the actual shares in financial markets, which are increasingly dominated by passive investors. Other model’s parameters are set to reflect the characteristics on U.S. stock markets. Our main findings are the following:
- The study finds substantial drops in the stock prices of brown firms excluded from the green index and increases in the prices of greener firms. In the baseline scenario, the price of brownest firms is reduced by 5.6% after 10 years, while the price of greenest firms slightly increases by 0.7%. During the same period, the cost of capital of brown firms increases by 20 basis points relative to the cost of capital of green firms.
- These effects occur primarily at the time of the announcement of the exclusion strategy and continue during the exclusion phase. The reason for the substantial price impact is that active investors must absorb the additional supply of brown shares by green investors, and they want to be compensated for being more exposed to these firms.
- The figure below illustrates how the price impact is affected for alternative calibrations of the share of green investors, while the share of active investors remains equal to 20% and the fraction of passive investors is adapted accordingly. Increasing the share of green investors from 10% to 40% amplifies the price impacts. The price of brownest firms falls by a moderate 1% relative to the price of green firms with only 10% of green investors, but by a more impressive 12% with 40% of green investors.
- The large effects at the announcement date imply a first-mover advantage to green investors who adopt the decarbonisation strategy early.
- We also compare the returns of a strategy that invests only in green firms to one that invests only in brown firms, over the ten years of the exclusion phase. This realised return trades off the negative price impact experienced by investors holding brown firms and the increased expected return paid by these firms. The green strategy outperforms the brown strategy over ten years, despite the higher expected return that brown stocks earn during the exclusion phase.
Conclusion
This policy brief emphasises the need for strategic policy interventions to support green investing. By promoting green indices, developing financial instruments to aid the transition of brown firms, and balancing regulatory frameworks, policymakers can drive significant progress towards a greener economy. The findings underscore the importance of green investors in shaping stock prices and highlight the benefits of early adoption of decarbonisation strategies.