Tuesday, July 4, 2017

The Future of Investing in Green

Shih-Fang Lo and Julia Yang


     There is a profit side and a responsible side to any business, and the two factors have to be balanced. With the threat of global warming and environmental deterioration, the government policy on environmental protection remains active from the last century worldwide.  Business will face more strict restrictions on energy uses and business process in the natural resources constrained society.  Governments’ environmental and energy policies are stimulating grand new industries, such as energy efficiency industry, new and renewable energy industry, and new services. The policy trends have not only created green new industry, but also brought growing green investment opportunity.  This article therefore aims to investigate what’s been happening in green finance and its prospect.

Green Finance Starts from Corporate Responsibility

     Recent financial scandals such as subprime mortgage crisis have emphasized the need for greater transparency and accountability.  A more humane, ethical, and transparent way of doing business is therefore broadly discussed. Take the term ‘corporate responsibility’ for example, the classical view from the shareholder approach is that the social responsibility of a business is to increase its profits and value for its owner.  However, the stakeholder approach points out that business is not only accountable to its shareholders, but should also consider stakeholder interests which may affect or may be affected by the operations or objectives of a business. It is gradually extended to ‘corporate sustainability’ defined as a business approach that creates long-term shareholder value by embracing opportunities and managing risk from three dimensions:  economic, environmental, and social dimensions. A sustainable company is one whose characteristics and actions are designed to lead to a ‘sustainable future state,’ such as value creation, environmental management, and human capital management, etc.

Green Investment Seeks for Long-Term Performance

     Companies that actively manage a wide range of sustainability (or green) indicators are better able to create long-term value for all stakeholders. ‘Responsible investment’ (or ‘Green investment’ hereafter) began appearing in the late 20th century and is an investing vehicle which reflects investors’ values and concerns regarding the impact and conduct of business activities.  It selects companies for investment considering the social and environmental performances as well as the financial performance.  The term ‘green investment’ is often used interchangeably with the term ‘social responsibility investment (SRI)’ or ‘ethical investment.’  Since some investors who are not only interested in the ‘maximization of shareholders’ wealth but also the maximization of stakeholders welfare’ will seek out those companies for an above average growth rather than a temporary outsized performance.  Following several scholars’ argument, it is believed that a substitution of longer-term sustainability for shorter-term volatility and risk is needed for today’s businesses.  Leading responsible firms are more likely to deliver predictable earnings with less negative concerns.  In other words, corporate governance and the firm’s economic, social and environmental performance can be effectively linked with adequate disclosure. Green investment has now been increasingly perceived as a mainstream element of good corporate governance, both from individual companies and of institutional investors, and good corporate governance can have good effects on long-term corporate financial performance.

Green Investment vs. Traditional Investment

     Traditional financial theory based on rational investors, efficient market, and profit maximization; however, those theories fail to explain some market anomalies after mid-1980s.  Previous empirical literatures define the so-called ‘market anomalies’ as the gap which cannot be priced by rational asset pricing model, such as ‘size effect,’ ‘weekend effect,’ ‘dividend effect,’ ‘January effect,’ ‘P/E effect,’ and ‘price/book ratio effect,’ etc. Moreover, there is emerging studies investigating the market anomalies about environment and energy related fields, which we call the ‘green anomalies’ as follows.

     ‘Eco-Efficiency Premium’: Global indexes, such as FTSE4Good Index and Dow Jones Sustainability Group Indexes, are designed to measure the performance of companies that meet globally-recognized corporate responsibility standards and to facilitate investment in those companies. Using common-used financial pricing tools, Capital Asset Pricing Model (CAPM) and Fama-French Three Factor Model, previous studies find that high ranked eco-efficiency portfolios have around 6% ‘eco-efficiency premium’ compared with low ranked portfolios. Using corporate eco-efficiency scores to form portfolios and use long-run buy-and-hold strategy.  High eco-efficiency S&P 500 portfolios have higher returns and lower volatility related with regular S&P 500 in the long-run. The eco-efficiency is positive with operating performance and market value, which imply that managers do not have to overcome a trade-off between eco-efficiency and operation performance.

     ‘Climate-Change Premium’: Connected to asset pricing theory, the literatures relating to climate-related investments are also emerging in the recent years. It is generally believed the climate-change premium exists in the long run, and related indexes tracking the performance can be categorized into:  (1) indexes that is comprised of firms with relatively low carbon emission, such as S&P U.S. Carbon Efficient Index, HSBC Global Climate Change Index, and UBS Europe Carbon Optimized Index. etc.; (2) indexes that measure the performance of the liquid carbon-related credit plans, such as Barclays Capital Global Carbon Index, MLCX Global CO2 Emissions Index, and SGI-Orbeo Carbon Credit Index, etc. Performance of climate-related indexes shown in previous reports can be deemed as probably climate change premium. For instance, HSBC announces the HSBC Global Climate Change Index and this index has outperformed with global equities.

From Green Awareness to Green Impact

     Accountability should be at the very heart of investment. Before ‘the Wealth of Nations,’ Adam Smith wrote ‘The Theory of the Moral Sentiments (1759),’ which states that a capitalist system must be based on honesty and integrity; otherwise it will be destroyed.  Adam Smith understood that self-interest should be moderated by responsible so that purely selfish or exploitative behavior would be the exception and not the rule in our society.  The business sector as well as financial sector has to honor the moral minimum or respect our nature and justice while making a profit.  Following the business scandals and corporate failures which occurred in the past few years, works to rebuild public trust in business and in the financial markets have been discussed extensively in practice. To be impactful rather than making paper money, financial sector may re-think to serve the real economy in a greener way.

(Shih-Fang Lo is the Associate Research Fellow for Green Economy, Chung-Hua Institution For Economic Research and the mentor of Green Impact Academy.

Julia Yang is the Founder of Green Impact Academy. Green Impact Academy acts as a Meet Market aggregator in green industries, providing talent development, marketing, and financial plumbing services to accelerate the growth of the green economy.)

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