Environmentally conscious investors and portfolio choice decisions

ABSTRACT

This paper presents a financial economic model that analyzes the effects of integrating environmental concerns into investment portfolios in capital markets. The environmentally conscious investor's expected rate of return on equity is shown to incorporate an environmental risk premium. Both the investors' degree of concern for environmental externalities and the environmental risk profile of a company are crucial for understanding why companies whose equity values are positively correlated with stricter environmental regulations exhibit a lower cost of equity capital. A closed-form solution to the environmentally-concerned investor is derived, offering insights into how the optimal portfolio relates to both the degree of concern for environmental externalities and the environmental risk profile of an equity stock.

KEYWORDS:

• Environmentally conscious investors
• environmental externalities
• regulation
• environmental risk profile
• portfolio choice
• inclusive wealth

JEL CLASSIFICATION:

• G11
• Q56
• D62
• D9

Acknowledgements

We would like to thank the editor and two anonymous referees for their comments and feedback that substantially improved this paper. We thank Phani Wunnava, David Garraty, Anna Visvizi, and Yaw Nyarko for insightful discussions and comments. We also thank workshop participants at the 2015 ASSA meeting in Boston, the 2014 SEA meeting in Atlanta, the 2014 International Atlantic Economic Conference in Savannah, as well as seminar participants at the Research Colloquium at Morehouse College and the Network Summer Scholar-in-Residence program at New York University.

Disclosure statement

No potential conflict of interest was reported by the authors.

ORCID

Johnson Kakeu http://orcid.org/0000-0003-3354-1762

Notes

1. See for instance, the UN's Sustainable Stock Exchanges initiative, the Natural Capital Declaration (NCD), the Principles for Responsible Investment (UN-PRI), the United Nations Environment Programme's Finance Initiative (UNEP FI), the CDP (formerly Carbon Disclosure Project), the Ceres, the Council of Institutional Investors, Global Reporting Initiative, the Interfaith Center on Corporate Responsibility, the Investor Environmental Health Network, the Montreal Carbon Pledge, and the Forum for Sustainable and Responsible Investment (US SIF).

2. Taking the dynamic of environmental externality/regulation as given may not be restrictive when examining a partial equilibrium model of a small investor's consumption-portfolio decisions, but when aggregation is the concern this assumption can be restrictive. In a general equilibrium model, environmental externalities should be endogenized, which is a topic beyond the scope of the present paper.

3. Thank you to an anonymous referee for pointing this out.

4. There are considerable uncertainties over the dynamics of environmental externalities (Pindyck 2007).

5. Investors are increasing alert to environmental information. In January 2010, the Securities and Exchange Commission issued a guidance to ensure that companies provide investors with meaningful environmental information regarding material impacts from climate-related developments. In April 2014, the European Parliament approved new rules that will require large listed companies to publish environmental information in their reporting to investors.

6. The shadow price is the increase in wellbeing that would be enjoyed if a unit more of the wealth were made available, when behaving optimally.

7. The dynamic of the optimal consumption is given bywhere is the consumption's instantaneous volatility.

8. It is assumed that there is a positive correlation between the degradation of the environment quality and the stringency of the environmental regulation.

9. For instance, defensive medical expenditures, healthcare costs, and expenditures on resilience equipments may be allocated to mitigating the disutility from health and physical impacts of climate change.

10. Environmental audit reports along with future expected changes in environmental laws and regulations may provide a useful source information in assessing the environmental risk profile of a company.

11. There is empirical evidence that companies companies that break environmental laws and engage in unethical behavior are likely to suffer meaningful decreases in the market value of company equity (Long and Rao 1995; Karpoff, Lott, and Wehrly 2005).

12. As empirically evidenced by Chava (2014), investors expect significantly higher returns from equities of companies that are heavy polluters.

13. For instance, changes in climate, such as sea level rise and more intense storm events, increase damage and destruction to buildings.

14. The parameter α may capture how strongly the inclusive wealth responds to the levels of greenhouse gas concentrations and features of the climate (e.g. temperature, precipitation, and sea level).

15. The author uses the KLD database, which provides information on environmental concerns and environmental strengths for a large sample of firms.

16. Some general results on the existence and the unicity of the solution to the Hamilton-Jacobi-Bellman equation based on the properties of the utility function or the properties of the drift and volatility of a state variable are discussed by Lions (1983).

17. As emphasized by the Bank of England Governor, Mark Carney, companies should provide investors with a more integrated reporting that includes environmental information and alongside financial information (Carney 2015, 2016). Along the same lines, the Climate Disclosure Standards Board (CDSB), which is an international consortium of business and environmental NGOs, has developed a framework for reporting environmental information alongside financial information that can prove useful for investors' portfolio allocation decisions. Some practical approaches used to incorporate environmental information into investment decisions include the screening approach and the best in class approach (Staub-Bisang 2012). These strategies can be used in combination as well as on their own. In the screening approach, some companies in environmentally damaging industries may be excluded from the portfolio. In a similar vein, companies may be included for their positive contributions to the environment such as those providing renewable energy, waste and recycling services, or organic farming. The best-in-class approach is an investment strategy that assures only companies that pass a certain environmental threshold test in a particular industry or asset class are included in the investor's portfolio choice. For example, in the energy sector, an investor might have criteria to invest only in power companies that have a better record on the environment issues.