Two scholars at Copenhagen Business School, Denmark have devised what they call a “text-based sustainability sentiment measure,” that is, a quantification of when and to what extent concerns about climate change are rising amongst investors, with a likely consequence for the success of an ESG-oriented trading policy.
The authors are Andreas Brogger and Alexander Kronies and both currently are visiting scholars at the Wharton School. Brogger is a former section head of systemic risk and macroprudential policy at the Denmark central bank.
The paper first contends that ESG investing yields “negative expected excess returns.” That sounds like a contention of pessimists regarding ESG investing as a whole, but Brogger and Kronies are not pessimists. They contend that ESG investors can be successful if they are both smart and unconstrained. They must be unconstrained by regulatory authorities or fiduciary responsibilities, so that they can chase the hockey puck—not where it is presently, but where it will be in the near future. Constrained investors go where the hockey puck is—and it’s never there by the time they get to where it was.
Speaking more literally, and in these authors’ own words, constrained investors, “chase high ESG stocks with high abnormal returns … with hope that the returns will persist.” But they don’t persist, which is why the overall expected excess returns of ESG are negative.
Not only can unconstrained investors win, but corporations with a lot of unconstrained ownership show a positive ESG premium in their stock performance. That is a choose-your-investors-wisely caution for managers.
Fundamental Analysis Pays Off
Put differently, socially unconstrained investors “seem to have a superior technology to detect ESG value, which may be explained by these firms spending a lot of money and energy on fundamental analysis of companies, which pays off. This finding could further explain why socially unconstrained firms earn superior returns when they invest in ESG firms. They detect those firms with ’ESG-potential’ and when this potential is realized, an increased demand in these stocks due to higher ESG scores lets prices appreciate and pay abnormal returns.”
These high returns are not explained by high risk. They are explained, rather, by sentiment, in defiance of the notion that asset prices are set by rational expectations regarding return and risk.
“Sustainability sentiment,” the Copenhagen authors suggest, could “be driven by an increase in the salience of, for example, climate change risks,” in the form of negative news coverage of climate. When these authors regressed their ESG factor on a dummy variable, that is, one which was one in periods when there was more than average bad news on climate, and zero otherwise, the ESG factor exhibited 73 basis points of abnormal returns in the bad-news periods. In quieter periods it did not exhibit any abnormal returns.
Their text-based means of measuring such sentiment turns out to be surprisingly simply. They simply used the number of Google searches for the phrase “climate change” over time, to get their measure of the salience of climate change risks.
A Critical Thought
This seems an overly simple metric. After all, there is no reason to believe the people Googling that phrase are especially likely to be making investment decisions. One might think that further research along these lines could work up alternative ways of measuring sentiment on the subject in a targeted way.
What is more, at least some of the people Googling “climate change” at any given time are likely looking for credentialed support for their climate-change denialism. It isn’t clear that the numbers here measure either the investing world’s or the general population’s urgency about the risks of climate change.
In their focus on sentiment, Brogger and Kronies are indebted to the work of Baker and Wurgler (2006). Baker and Wurgler examined “cross-sectional predictability patterns in stock returns” working with proxies for beginning-of-period sentiment.
Brogger and Kronies, using much the same method, find that “a falling price dividend ratio is associated with positive returns on the ESG factor, hinting that investors care about ethics in times of crisis.” Indeed, they end with the hopeful notion that investor sentiments may “[nudge] the economy toward a more sustainable future, as more sustainable projects will be financed.”