The Unstoppable Rise of Sustainable Investing

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Climate change is slowly transforming our living environment, but it is not unusual for many people not to take this seriously until they experience it on a personal level. Due to the limited span of attention that everyone possesses, individuals are inclined to concentrate more effectively on infrequent dramatic changes rather than frequent gradual changes.

Therefore, extreme local temperatures, such as the hottest summer on record for Europe and China in 2023, may serve as a “wake-up call” for people to realise the full extent of climate change risks. Consider that Hong Kong recorded its hottest day ever in September 2023, with the temperature exceeding 34 degrees Celsius, and a report from The European Space Agency estimated that temperatures in Italy exceeded 50 degrees Celsius.

In September 2022, more than 500 institutional investors with US$39 trillion in assets under management signed a statement, advocating for governments to implement ambitious policies to combat the climate crisis effectively. EY Global Corporate Reporting Survey 2022 found that 78% of investors prioritise environmental, social, and governance (ESG) initiatives over short-term profits, although only 55% of businesses are willing to align their focus accordingly.

So how do investors react to abnormal local temperatures? Do people’s attention to global warming affect financial markets?

How Climate Change Sways Markets

In the study titled Attention to Global Warming, Associate Professors in the Department of Finance at the Chinese University of Hong Kong (CUHK) Business School, Darwin Choi, Zhenyu Gao and Wenxi Jiang, analysed temperature and financial data in 74 cities with major stock exchanges, including London, New York, and Hong Kong. The team found that the volume of Google searches for the term “global warming” increased when people were experiencing unusually warmer weather, and that people living in cities with higher abnormal temperatures were more likely to search for relevant information than those living in cities with lower temperatures.

Investors in these cities also adjusted their trading activities. The researchers found that carbon-intensive firms earn lower stock returns than those with low carbon footprints during abnormally warm weather.

“Our research suggested that it is only by appealing to the personal and salient experiences of individuals can the challenge of global warming be most effectively tackled,” says Prof. Choi.

Investors also tended to sell stocks that are highly sensitive to climate change, such as those that belong to industries identified as major emission sources by the Intergovernmental Panel on Climate Change (IPCC), an intergovernmental body of the UN established to assess the science related to global warming, or if they have higher carbon emission levels relative to industry peers as estimated by MSCI ESG ratings. On the other hand, investors tend to buy stocks that are less climate change-sensitive as they outperform the former.

The researchers also found that not all investors act in the same way. Their findings indicated that retail investors tend to be more easily affected by abnormal weather, but no evidence that the same was true for institutional investors.

As a critical long-term issue, global warming requires collective human action. The study indicated that the most effective approach to addressing this challenge is by connecting with individuals through their personal and significant experiences, such as by using maps to demonstrate how the potential rise in the sea levels as temperatures rise will affect everyone. The researchers expect that when the general population has a better understanding of the severity of global warming, the link between abnormally warm weather and stock prices will weaken.

Power of Institutional Investors

As large market participants, the actions of institutional investors such as banks, mutual funds, pensions and insurance companies strongly influence the overall market. But how do they react to climate change?

In another research, Measuring the Carbon Exposure of Institutional Investors, Prof. Choi, Prof. Gao, and Prof. Jiang sought to analyse institutional investor exposure to stocks of carbon-intensive US firms, and to systematically examine whether they reduced their vulnerability to climate change as the world became increasingly concerned about its effects.

Using the IPCC-based classification to identify all US stocks, the team then analysed how institutional investors reacted to climate risks. The results found that, in the past two decades or so, large-scale investors have generally reduced their holdings in high-emission companies, from overweighting the stocks of high-emission firms, relative to the market, by 0.5 percent in 2001 to underweighting them by 0.2 percent to 0.7 percent since 2015. 

“Our findings support the notion that institutional investors are generally becoming more aware of climate risks and actively avoid industries with high carbon footprints,” says Prof. Gao.

This decline has coincided with the mainstreaming of calls for institutional investors to divest fossil fuel-related holdings and to invest in renewable energy, around the same time. The research findings indicate that institutional investors are increasingly recognising climate risks and actively avoiding industries with significant carbon footprints, similar to how they approach “sin” stocks like tobacco, alcohol, and gambling based on ethical considerations.

The researchers also extended their analysis to before 2000, but they did not see a corresponding decline in institutional ownership of high-emission stocks, presumably because climate change was less of a concern at that time. This result complements their previous research on the impact of global warming on retail investors, suggesting that both individual and institutional investors are increasingly taking heed of climate risks in their decision-making.

Impact of Regulatory Risk

While many studies have shown how climate change affects the portfolio choices of institutional investors, less is known about its impact on the investment decisions of individual households. In a study titled Climate Change and Households’ Risk-Taking, Prof. Gao and Chanik Jo, Assistant Professor in the same department, sought to answer these questions by focusing on regulatory risk.

Prof. Gao and Prof. Jo looked at whether high-emission households in the US adjusted their investment portfolios following the adoption of climate change-related action plans in the states they live in. For example, Florida introduced an energy and climate change plan in 2008 that contained 50 policy recommendations to reduce greenhouse gas emissions. Compared to other families, the study found that the adoption of such a plan resulted in high-emission households reducing their holdings of risky assets by 15 percent.

The researchers then found that more stringent climate regulations resulted in a more significant reduction in holdings of risky assets by high-emission households. The data showed that a one standard deviation increase in the level of stringency in enforcement by the US Environmental Protection Agency led to a reduction of holdings of risky assets by 2.75 percent. The adoption of climate-related action plans or changes in enforcement did not affect the investment choices of households that are not employed in high-emission industries.

Additionally, another significant implication of the findings is that climate regulations may have unintended consequences for households in high-emission industries, which tend to be less wealthy, younger, and less well-educated. However, this does not necessarily mean that society is generally worse off as a result of climate regulations.

“We found that climate regulations may reinforce wealth inequality by deterring less wealthy households from participating in stock markets,” says Prof. Jo.

To mitigate exposure to climate change risks, households may choose to leave a high-emission industry altogether. When climate change regulatory risks rise, the study found a significant movement among households to work in companies that are considered less polluting. Households that switch industries allocate more money to risky assets than those that stay in high-emission sectors.

Therefore, it is important for policymakers to understand the implementation of climate regulations in a manner that does not increase income risks for households employed in industries most affected by climate change regulations.

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About the Researchers

Prof. Darwin Choi
Prof. Darwin Choi is an Associate Professor in the Department of Finance and Associate Director of the Centre for Business Sustainability. He received his PhD degree in finance from Yale University and BS in Economics and BS in Engineering degrees from the University of Pennsylvania. His recent work focuses on climate finance and other ESG issues. 

Prof. Zhenyu Gao
Prof. Zhenyu Gao is an Associate Professor in the Department of Finance. He received his PhD in Economics from Princeton University and MA in Economics as well as BS in Astrophysics from Peking University. His primary research interests are in asset pricing, behavioural finance, real estate finance, and Chinese economy.

Prof. Wenxi Jiang
Prof. Wenxi Jiang is an Associate Professor in the Department of Finance. He obtained a PhD in Financial Economics from Yale University and a bachelor’s degree from Renmin University of China. His research interests include asset pricing, institutional investors, and behavioural finance. 

Prof. Chanik Jo
Prof. Chanik Jo is an Assistant Professor in the Department of Finance. He received his PhD in Finance from the University of Toronto, MS in Management Engineering from The Korea Advanced Institute of Science and Technology, and BBA/BE from Sogang University. His research focuses on the intersection of asset pricing and household finance.