Are Institutional Investors Taking Stock of Climate Change?

Climate change, including global warming and an increased risk of extreme weather events, from heatwaves to storms and floods, is widely considered one of the greatest existential threats facing human kind. Perhaps recognising the influence exerted by financial markets in policing firm behaviour, environmentalists have over the last decade and a half accelerated their efforts to advocate market participants take a more responsible approach in their investment decisions. For example, a campaign called Fossil Free: Divestment that aims at stopping investment in fossil fuel companies has attracted the attention of high profile organisations such as the philanthropic foundation Rockefeller Brothers Fund.

But how successful have environmental campaigners been in affecting behavioural change among financial market participants? Are institutional investors staying away from carbon intensive stocks as a result? A group of researchers at The Chinese University of Hong Kong (CUHK) Business School think they have the answers.

The researchers – Darwin Choi, Gao Zhengyu and Jiang Wenxi, all Associate Professors at CUHK Business School’s Department of Finance, found that investors have significantly reduced their investments in carbon-intensive stocks since around the time the financial sector began to become more aware of environmental issues around 2015 and this wave of divestment has even led to increasing pressure on publicly-listed firms into taking a greener approach in their business operations and reduce their carbon footprints.

The new research results also come amid the recent publication of a comprehensive UN report that sounded a dire warning on climate change, noting that greenhouse gas emissions have already passed a point of no return that will prevent temperatures from rising over at least the next two decades.

The trio of CUHK researchers have long been studying the influence of global climate change on financial markets. An earlier paper, Attention to Global Warming, argued that retail investors pay more attention to climate change and sell down high-emission stocks after experiencing extreme weather conditions personally. Following on from this earlier research, they turned their attention to how climate change has impacted the heavyweight players on the investment sector – its institutional investors – in two new studies.

“Global warming is the reality that we live in. We already knew from our previous studies that climate change is an issue that affects investment decisions for individual retail investors that purchase stocks with their own money,” says Prof. Choi. “What we wanted to find out was whether it had a similar effect on the larger players in the investment market. Do the big market players from sovereign wealth funds, asset managers, university endowments, pensions to insurance companies, that invest money on behalf of other people and who have comparatively greater clout and influence, behave in a similar way?”

Measuring Divestment

In one study, titled Measuring the Carbon Exposure of Institutional Investors, the three CUHK academics first constructed a new scoring system to categorise listed companies in the U.S. as either high- or low-emissions. They then used this system to analyse how institutional investors with more than US$100M assets under management (AUM) reacted to climate change.

The study found that this group of institutional investors reduced their holdings of high emission stocks. They went from overweighting carbon-intensive stocks (relative to the market index) by around 0.5 percent in 2001, to underweighting them by between 0.2 percent and 0.7 percent in the period since 2015. Such a trend was not observed before the year 2000 when climate change awareness was less widespread.

“Our results suggested that big institutional investors are avoiding high carbon emission stocks just like they are doing with so-called “sin” stocks, such as tobacco, alcohol and gambling because these companies made products that were considered unethical,” Prof. Gao says.

“Having settled this point, what we then wanted to find out was whether divestment by such a big and powerful segment of investors would actually make these environmentally “sinful” companies do good,” Prof. Gao says.

Institutional Pressure

This is question that the three CUHK researchers sought to address in their study titled Global Carbon Divestment and Firms’ Actions, which was conducted in collaboration with Mr. Zhang Hulai at Tilburg University. In this study, the researchers looked into how climate change affected a listed company’s stock price valuation and whether this channeled down into its business decisions.

The researchers used data from 23 countries to measure financial institutions’ exposure to stocks in high carbon emission industries, which are mainly in five categories: energy, transport, building, industry (such as those producing chemicals and metals) and agriculture/forestry. They then calculated a carbon ratio, which they defined as the weight of total high-emission stocks in a financial institution’s stock portfolio. The study results showed that the aggregate carbon ratio fell over time relative to the market index, and the downward trend happens at the same time as when steam began to pick up behind climate campaigns that sought to influence stock market investment behaviour such as the Fossil Free: Divestment campaign and Go Fossil Free campaign, as well as the adoption of the Paris Agreement – the international treaty on climate change – around 2015.

According to the study, the ratio of a high-emission listed company’s market capitalisation to its total earnings (also known as a price-to-earnings, or P/E, ratio), tended to be lower after 2015 if the company is located in a country with high climate change awareness. This was calculated based on a survey that sampled individuals’ opinions on climate change from 111 countries. It found that a one standard deviation increase in climate awareness is linked to a six percent decrease in the high-emission public firms’ price-to-earnings ratio, meaning that the company may be undervalued.

In addition, the study found that high-emission public firms situated in countries with strong environmental awareness also reduced their emissions from 2016 to 2018. It found a one standard deviation in climate awareness increase was associated with a 5.5 percent decrease in emissions by high-emission public companies. Furthermore, these public companies also increased their expenditures on upgrading their physical assets, research and development and filed more patents on products or processes that can provide benefits to the environment. Specifically, a one standard deviation increase in climate awareness was linked to a 3.49 percent increase in capital expenditure, a 6.49 percent increase in R&D investment and a 2.4 percent increase in green patents.

Growing Environmental Lobby Influence

However, the same results were not observed among high emission private firms. The researchers thought that perhaps private companies did not face the same amount of divestment pressure from large institutional investors.

“We’re not privy to the specific conditions under which individual firms make their operational decisions and thus we cannot claim that there’s a causal link. However, at the very least we are able to confidently say that the financial decisions made by the big institutional players in the investment sector, as well as those made by publicly-listed firms that affect their daily operations, go in the same direction. That direction is one that leads to lower carbon emissions and helps combat climate change,” Prof. Jiang says.

“What this means is that campaigning by environmentalists has led and is leading to a change in behaviour among large institutional investors, and this is possibly filtering down to real decisions that businesses make on the ground.

“Environmental awareness is a theme that we expect to continue to exert an overarching influence on finance, and this will grow with the proliferation of socially responsible investment funds and as our concerns over climate change become greater the hotter our planet gets,” says Prof. Jiang, adding that a possible avenue for future research is to look into greater detail the mechanism under which institutional investor pressure can lead to changes in operational behaviour by companies that lowers carbon emissions.