Fund managers play an important role in translating environmental concerns into asset prices
In a recent paper (1), EDHEC Professors Teodor Dyakov and Dominic O’Kane study the impact of climate salience on the investment decisions taken by more than five thousand fund managers around the world. Do managers update their preferences for green assets following prolonged heatwaves? Is that informative for the risks and returns of sustainable investment?
The promise of Paris and the uncertainty of investor behaviour
The Paris agreement, signed in 2015, calls for the global average temperature increase to remain below 1.5°C above pre-industrial levels. It specifically asks that we “mak[e] finance flows consistent with a pathway towards low greenhouse gas emissions and climate-resilient development” (UN, 2015) (2).
The public expectations beg the question about the role played by mutual funds. Fund managers are what we refer to as “marginal investors” – that is, because of their prominence in financial markets, their decisions are likely to determine the direction asset prices take.
Typically, if funds as a group buy a stock, its price is likely to go up. Yet, our understanding of how fund managers incorporate environmental concerns in their investment decisions is limited.
Investments in “green” stocks by managers following extreme climate events
In their recent paper “Climate Salience and the Demand for Green Stocks by Mutual Funds“ (1), T. Dyakov and D. O'Kane gathered a sample which spans the investment decisions of 5,189 actively managed mutual funds, located in 242 distinct locations across 24 distinct countries.
Because of the global locations of asset managers, the paper exploits cross-sectional variation in climate salience that allows the authors to identify a clearly defined counterfactual. For example, a manager located in Paris is likely to update her beliefs about climate change following a heat wave in France, while a manager located in New York would not.
Thus, the authors compare the investment decisions of a “treated” group of funds experiencing extreme climate temperatures (i.e, concerns about climate change become more “salient”) against those of a “control” group of funds not subject to extreme temperatures.
The authors use company-level emissions as a proxy for stock greenness, instead of the highly contested ESG ratings. Emission levels and intensities are relatively easy to interpret and understand and are popular among both academics and practitioners.
T. Dyakov and D. O’Kane show that managers respond to the increases in climate salience with an increase in investments in green assets. For example, when average temperatures during the previous 12 months exceed one standard deviation in temperatures, that is, 2 degrees Fahrenheit or 1.1 degrees Celsius, an expected 10% decrease in a company’s level of emissions is associated with a 3% increase in the number of funds buying its stock during a given quarter. Thus, in the aggregate, climate salience is associated with a “greening” of the investments of mutual fund managers.
The trading and return patterns the authors document indicate that these demand changes are driven by an update of managers’ perception about climate change. Importantly, the investment decisions of the “treated” funds lead to the subsequent outperformance of the stocks fund managers buy relative to the stocks they sell. The outperformance lasts for two quarters and is not followed by reversals.
The increase in performance is consistent with the theory of Pastor et al. (3). In this theory, the outperformance of green stocks can be attributed to:
a) re-evalulation of the cash flows of green versus brown firms, and
b) an increased wealth-weighted fraction of environmentally conscious investors.
The authors construct a simple trading strategy that exploits the outperformance of green stocks and find that it generates 0.36% per month after adjusting for exposure to common risk factors.
Why does it matter?
There are several theoretical and empirical studies that show that green firms outperform brown firms following increases in environmental concerns (3) (4). A missing piece in the broader picture is which financial actors contribute to those effects.
The study by Dyakov and O’Kane provides an answer – when environmental concerns increase, mutual fund managers increase their demand in green stocks, leading to the outperformance of green stocks relative to brown ones. Thus, if environmental concerns increase in the future, we may observe similar price patterns.
References
(1) Climate Salience and the Demand for Green Stocks by Mutual Funds (2024) T. Dyakov and D. O'Kane, SSRN paper - https://papers.ssrn.com/sol3/papers.cfm?abstract_id=5008435
(2) Paris Agreement. United Nations Treaty Collection (2015) Page 3 - https://unfccc.int/files/meetings/paris_nov_2015/application/pdf/paris_agreement_english_.pdf
(3) Pastor, L., Stambaugh, R. F., and Taylor, L. A. (2021). Sustainable investing in equilibrium. Journal of Financial Economics, 142(2):550–571 - https://doi.org/10.1016/j.jfineco.2020.12.011
(4) Ardia, D., Bluteau, K., Boudt, K., and Inghelbrecht, K. (2022). Climate Change Concerns and the Performance of Green Versus Brown Stocks. Management Science - https://doi.org/10.1287/mnsc.2022.4636
Choi, D., Gao, Z., and Jiang, W. (2020). Attention to Global Warming. The Review of Financial Studies, 33(3):1112–1145 - https://doi.org/10.1093/rfs/hhz086
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