Can sustainable divesting pressure companies to improve their environmental profiles?

Do institutional investors take into account firms’ climate exposures in setting up stock portfolios? And, if they do, what are the effects on the cost of equity of the firms they are investing in (or divesting from) and the resulting effects on the firms’ future environmental profiles?

A common narrative in climate finance is that if an investor cares about the climate and a company is negatively contributing to the environment, then the investor will ‘punish’ the company by underweighting the stock in their portfolio. As a result, the cost of equity will increase and the company will face an increased cost of capital as a result, reducing shareholder returns and making it more difficult for the firm to finance projects.

The company, consequently, may be forced to change its environmental profile ­­— for example by looking to greener alternatives — to mitigate these negative effects, so that in the future investors will instead invest in the company, leading its cost of equity to decrease.

However, is this what really happens? Evidence is mixed on how institutional investors’ climate-related rebalancing activities affect companies’ cost of equity and environmental profiles. In our Robeco-awarded paper ‘Climate-Triggered Institutional Price Pressure: Does it Affect Firms’ Cost of Equity?’, Cheng Xue, also from Queen Mary University of London, and I revisit this question. We examine whether the price pressure induced by institutional investor portfolio rebalancing — as triggered by firms’ physical and transition climate change exposures — affects their cost of equity and future environmental profiles.

Typically, companies have climate exposures — whether physical, such as risks for an insurance company to reimburse customers for a natural disaster, or regulatory, such as when an energy company faces new pollution rules — that may cause investors to invest in or divest from that company.

Divesting from a company, however, is different from boycotting it: another investor then still buys that stock, meaning it is not clear whether divestment can have any real effects on a company and its environmental practices.

Assessing impact and exposure
To assess the impact of rebalancing activities triggered by climate change considerations, we developed a measure called ‘climate change price pressure’ (CCPP). This captures the pressure on the stock price of a company when institutional investors change their portfolio weight of the firm because the climate change exposures of that firm have increased.

CCPP incorporates the portfolio rebalancing activities of all institutional investors by weighting their activities by the fraction of ownership of the investors. For instance, in the case of a hypothetical XYZ stock, if institutional investors perceive an increase in the climate exposures risk for XYZ, they may be likely to sell the stock, causing XYZ’s price to go down. CCPP measures this price pressure effect by taking into account the portfolio rebalancing activity triggered by climate change exposures to stock price of investors.

We calculated CCPP for every stock in the S&P 500 universe from 2005 to 2021 (we selected S&P 500 constituents as they account for 80 percent of the total market capitalization of US public companies). To calculate CCPP we need to proxy the climate change exposures of firms by using measures developed by previous researchers, which capture the intensity of discussions between management and analysts on company climate exposures.

These textual measures have several advantages over standard measures of climate exposures: first, they capture insights from earnings calls not necessarily captured in ESG ratings; second, these data come at a higher frequency compared to ESG ratings, as earnings calls happen quarterly versus annually; and third, these data dissect climate change exposures into physical, regulatory and technological exposures. We find that the average CCPP is sizable, increasing the stock price by 7.9 percent on average. This manifests that on average institutional investors take firms’ climate change exposures into consideration when forming their portfolios.

Next, we examine the effect of CCPP on the firm’s cost of equity. As some measures may rely on realized returns, or on information contained in the firm’s financial statements, these can suffer from biases. We bypass these biases by measuring the cost of equity for each firm in the S&P 500 universe using information from the equity options market, contained in the OptionMetrics IvyDB US database. These allow us to compute a firm’s cost of equity in real-time and in a more reliable way.

We proxy the expected returns as the cost of equity of the firms as a function of their risk neutral variances and the risk-neutral variance of the S&P 500. OptionMetrics is regarded as the gold standard in options data for academic and financial research.

Climate, companies and investors
We arrived at three key findings. First, CCPP does affect the cost of equity of the firm. When CCPP becomes more intense — when investors are selling the stock — the cost of equity of the firm goes up. We find that, on average, when investors underweight companies with high climate change exposures, this creates a large CCPP, which may increase firms’ cost of equity by up to 6 percent of their average value. This estimate incorporates activities of all institutional investors, who may be reacting in different ways.

Second, even though the cost of equity increases for firms due to climate exposure, the future environmental profile of the firm does not change. In other words, even though institutional investors are increasing the cost of equity of the firm (by divesting from it given increasing climate pressures) the firm does not take any actions. A key reason for this is that when a firm decides to change its operations to better address climate change, this has a cost.

It may need to adopt cleaner technology, retrain personnel or completely change corporate culture, none of which are easy or cheap. Management would then assess the cost of reforms alongside the cost of equity going up.

Because firms continue to not take greater climate actions even as their cost of equity increases by up to 6 percent of its average value, this implies that the expense of making the necessary changes is greater than the 6 percent increase in the average cost of equity.

Third, and interestingly, there is an exception to the above: when media attention on climate change risks in the economy increases, it generally leads to firms taking action. We suspect that the reason for this is that managers of the firm may realize that they will be facing reputational costs if they do not act. When the media starts writing about climate risks, public attention rises and firms that may be polluting are under even greater scrutiny. Management then starts taking action to avoid reputational risk.

Conclusions
So, what do these findings imply for institutional investors, firms and the climate? First, CCPP measures can help regulators to detect which investors are greenwashing. If an asset management company is promoting ‘green investing practices’ and that it constructs its portfolio by underweighting the firms of stocks with high climate change exposures, yet the CCPP figure suggests otherwise, then this could suggest it is not considering climate change exposure after all.

Second, it may affect how firms might be convinced to decrease their climate change exposures. Given that divesting does not tend to force firms to improve their environmental profiles, an alternative route is institutional investors engaging with firms’ management. This underlies the importance of maintaining strong climate coalitions aimed at promoting greener business practices. However, recently we have witnessed leading institutional investors departing from coalitions such as Climate Action 100+, thus making them weaker.

Finally, our results show that media does have an important role to play in incentivizing companies — and their management — to combat climate change.

George Skiadopoulos is a professor of finance at the University of Piraeus and Queen Mary University of London