The growing urgency of climate change has increased scrutiny of companies’ ESG (Environmental, Social, and Governance) practices. Investors are now more inclined to support firms that demonstrate strong ESG commitments, often willing to pay a green premium for sustainable investments. However, is the spread in performance between the ‘Sin’ and ‘Saint’ stocks driven by the ESG factor or some other omitted variable? The recent study by Zhan Shi and Shaojun Zhang suggests that the hidden force that may be in play is the price of the oil.
Analysis of authors challenges the prevailing view that greenium variation primarily reflects investor commitment to climate-aware investments. Instead, they show that oil demand fluctuations dominate in driving these variations. When oil demand rises, growth opportunities improve for carbon-intensive firms, such as those in the oil-and-gas sector, reducing the greenium in both U.S. and international markets. This suggests that financial markets respond more to oil demand shocks than climate policy risks or sustainability preferences. While this paper focuses on the greenium, oil prices have broader implications for carbon pricing, firms’ capital budgeting, bank lending, and corporate behavior. Further research on the role of oil prices will deepen our understanding of climate regulation, sustainable investing, and the transition towards net-zero economies.
These results raise concerns about how effectively markets are pricing in the carbon transition risks and the market’s potential contribution to decarbonization efforts. In light of this, more decisive policy interventions may be required to ensure that brown firms take adequate measures to address climate change. By recognizing the influence of oil demand on the greenium, policymakers can better assess the impact of regulations on firms’ cost of capital and carbon transition efforts. And we, investors and traders, can better understand which forces are in play when we assess the contribution of individual risk factors to the overall performance of our portfolios.
Authors: Zhan Shi, and Shaojun Zhang
Title: Oil-Driven Greenium
Link: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4998230
Abstract:
Driven by climate policy risk and investor pressure, many argue that carbon-intensive firms face increased costs of capital, creating a “greenium” favoring green firms. We challenge this view, showing that oil demand fluctuations drive much of the greenium variation by boosting product prices and growth prospects for carbon-intensive, oil-dependent firms, thereby reducing their relative cost of capital. This effect holds across U.S. bonds, equities, and international markets. Revisiting key climate-related events like the Paris Agreement, we find that investor discipline plays a minimal role once oil’s impact is considered. These results suggest that markets may be less climate-responsive than expected.
As always, we present several engaging figures and tables:
Notable quotations from the academic research paper:
“In this paper, we challenge this prevailing narrative that the documented greenium variation reflects genuine investor commitment to climate-aware investments. Many carbonintensive firms are concentrated in oil and gas industries, where their product price and valuation are closely tied to fluctuations in the oil market (see Figure 1). As such, fluctuations in oil prices can directly impact their cost of capital. The oil price has experienced several booms and busts over the past two decades, which coincide with periods of various climate events. Hence, fluctuations in the greenium might have been mistakenly attributed to climate policy risk or sustainable investors when in fact they reflect time-varying risks that affect oil-dependent firms. Indeed, our analysis reveals that these oil-related shocks play a significant role in explaining variations in the greenium. After accounting for the influence of oil prices, we find that investor discipline surrounding key climate-related events, such as the Paris Agreement, has only modest, if any, effects. Overall, financial markets may not be as responsive to climate crises as previously assumed.
Our empirical analysis supports these model predictions with robust evidence. First, we observe a significant pass-through of the real oil price to the relative output prices between brown and green firms. Second, the real price of oil positively correlates with various measures of growth options, including brown firms’ Tobin’s Q, return on equity, asset growth, and sales growth relative to green firms. Empirically, controlling for various firm characteristics can only partially account for the relation between oil price and future firm growth. This underscores the necessity of explicitly considering the oil price level in climate-related event studies, as firm characteristics alone cannot adequately capture the dynamics at play.
In sum, the model predicts that oil demand is negatively associated with the greenium. Higher oil demand is associated with higher marginal Q, asset growth, sales, and profitability for brown firms compared to green ones. In contrast, lower oil demand is associated with lower brown-minus-green Q spread, lower asset growth spread, lower profitability spread, and higher greenium.
Figure 2 plots the greenium and oil price time series. Consistent with the regression evidence, the oil price has a correlation of -0.49 with both scope 1 and 2 bond greenium, and a correlation of -0.32 and -0.19 with scope 1 and 2 equity greenium, respectively. Visual inspection of the plot yields several insights. First, the greenium varies substantially throughout the sample but becomes more elevated from mid 2014 onward. For example, the bond greenium has been mostly positive since this period, a trend that aligns with the below-mean real oil prices observed over the same interval. Second, past two decades have witnessed two significant boom-and-bust cycles in the greenium. The oil price crashes closely coincide with peaks in the bond greenium. The first oil bust occurred from 2014 to 2016, with oil prices bottoming out in January 2016, coinciding with the bond greenium peak. Similarly, the second oil bust took place in 2020, with oil prices reaching their lowest point in April and the bond greenium peaking in March. A analogous pattern, albeit less pronounced, is observed in the ICC-based equity greenium. Third, the greenium becomes more elevated from 2018 to 2020 and experiences a reversal subsequently, mirroring the rise and fall of sustainable investing. The figure shows that the oil price briefly peaked in 2018 before dropping to the sample low in 2020 and steadily recovering afterward, a movement that accounts for the rise and fall of greenium.”
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