Climate change : the transition risk : an empirical analysis of the inclusion of a Green-Minus-Brown factor in common factor models

Abstract

The transition towards a greener economy is highly uncertain. This thesis explores the impact of transition risk on equity prices. More specifically, we first study whether di↵erences in return between companies with high climate-related performance (Green companies) and low climate-related performance (Brown companies) can be explained by common risk factors included in the CAPM, Fama French threefactor and Carhart four-factor model. Subsequently, we extend these models with a Green-Minus-Brown (GMB) factor, and analyze whether the factor possesses unique return-a↵ecting properties that will have a statistically significant impact on the explanatory power of common factor models. The analysis is conducted on stocks included in the iShares MSCI World ETF in the period from January 2014 to December 2019. We find that di↵erences in return between a Green and Brown portfolio cannot be explained by common risk factors. Yet, there are no significant di↵erences in abnormal returns. Moreover, our results indicate that common factor models extended with the GMB factor explain variations in risk-adjusted return better than the original models. Our findings suggest that a transition towards a low-carbon economy will be profitable for Green companies, whilst Brown companies will su↵er from losses. However, both Green and Brown companies are exposed to high transition risk because of the uncertainty of the transition pathway.