Scientific Beta: When Greenness is Mistaken for Alpha

Scientific Beta: When Greenness is Mistaken for Alpha

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Low carbon investing products are typically built on the assumption that green stocks produce positive alpha. Economic theory contradicts this assumption: all else being equal, green firms should earn lower returns than brown firms because they provide non-pecuniary benefits and risk-hedging benefits to investors. The empirical literature does not support the claim of positive alpha for low emission firms either. This paper analyses how low carbon strategies can be mistaken for alpha and what the consequences are for investors.

First, we show that low carbon strategies can easily be mistaken for alpha when ignoring exposure to well-known equity factors and estimation error. Analysing US equity and carbon emissions data, we show that there is apparent alpha due to a long-short low carbon factor, which delivers positive returns over our sample period with 1.74% per year. However, this alpha becomes negative at -0.32% per year when adjusting for equity style factors, and it disappears entirely when accounting for estimation error. The profitability factor plays a central role in bringing down the alpha of the low carbon factor: 85% of average return is explained by exposure to the profitability factor. Moreover, returns of low carbon strategies display a negative relation with fossil fuel prices. Performance during periods of declining fossil fuel prices is thus inflated.

Second, we document the costs borne by investors who build portfolios with a mistaken belief in a positive low carbon alpha. This cost is substantial. Multi-factor portfolios that impose positive weights on the low carbon factor have an inferior risk-return profile: A low carbon allocation of 40% leads to giving up 100bp of annualised returns on a risk-adjusted basis. Note that this result occurs despite the positive returns of the low carbon factor. Increasing investment in the low carbon factor leads to a reduction in factor diversification due to overlap with the profitability factor and thus to low returns per unit of volatility within a multi-factor portfolio. Mistaking positive returns for positive (multi-factor) alpha is indeed costly for investors.

Third, we analyse the shortcomings of portfolio construction approaches used in low carbon investment products. Such approaches exploit highly granular information in stock-level scores to combine carbon objectives with equity style factors. We assess the incremental performance benefits from exploiting stock-level scores. On the one hand, allowing strategies to use scores more aggressively, by tolerating higher tracking error, does not improve performance. Annualised returns increase marginally until annualised tracking error reaches 2% to 3%, and then decrease if tracking error is allowed to increase further. This finding reflects the fact that carbon scores are not informative about expected returns, and scores for equity style factors are not reliable at the individual stock level. On the other hand, using scores more intensely increases portfolio concentration and impedes investability.

Our results suggest that using low carbon strategies as a source of alpha is costly to investors. This does not imply that investors cannot benefit from low carbon investing. Investors should analyse whether low carbon strategies can help them hedge climate risks or make a positive impact on corporate behaviour.

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