Green is good: Risk insights into Indian green stocks

While consistent financial flows towards climate resilience are crucial, there is a recent global trend of withdrawal of investment from ‘green assets’. Given the centrality of potential risk-adjusted returns in investor decisions, this article analyses publicly available daily data on domestic and global stock market indices for the period 2008-2024 to assess the dynamics of market risk of Indian green stocks.

Human activities in recent years which have adverse effects on the environment have raised the average global temperature significantly above the pre-industrial level (that is, the level of temperature that prevailed during 1850-1900). In fact, 2023 was the warmest year since 1850: the average temperature was a staggering 1.35°C above the pre-industrial average. If this trend continues, the climate is expected to further warm up by 1.5°C between 2030 and 2052 (Intergovernmental Panel on Climate Change (IPCC), 2018).

The Paris Agreement aims to keep the increase in global temperature below 2°C, with efforts to limit it to 1.5°C. According to IPCC, if we cross the 1.5°C threshold, the consequences will be more severe and catastrophic. There are likely to be more intense and frequent heatwaves, faster rising sea-levels, a higher risk of species loss and extinction, and more extreme weather events such as floodings and storms, which will affect hundreds of millions of people worldwide. The Paris Agreement also advises to keep financial flows consistent towards climate resilience and low greenhouse gas (GHG) emissions (United Nations Framework Convention on Climate Change (UNFCCC), 2015).

Socially responsible investment

Recent years have witnessed a significant increase in socially responsible investment. According to a Bloomberg Intelligence Report, global ESG assets (investments that are strongly aligned with environmental, social and governance factors) crossed US$30 trillion in 2022 and were projected to exceed US$40 trillion by 2023. This amount represents over one-fourth of the projected US$140 trillion assets under management by 2030. However, in the recent past there has been a significant outflow from sustainable funds in the United States – investors pulled US$5 billion in Q4 of FY2022-23, followed by a record US$8.7 billion in Q1 of FY2023-24, marking the sixth consecutive quarter of outflows. In fact, Q4 of FY2022-23 also witnessed an outflow of $2.5billion from global ESG funds for the first time, before bouncing back with a net inflow of US$900 million in Q1 of FY2023-24.

The trend of withdrawing funds from the green assets must be arrested and reversed. However, persuading investors to invest in green asset on the basis of ethical reasoning alone is difficult. They must be convinced of the potential returns from their investments. Evidence shows that the risk-adjusted returns from green stocks outperformed the most polluting stocks by 3.7% per year in the global market since 2000 (Levi and Newton 2016), socially responsible US domestic-equity mutual funds performed better during crises that occurred between 2000 and 2011 (Varma and Nofsinger 2014), and adopting greener technologies had a positive impact on profit margin and stock prices for large companies in the US and globally (Bhat 1999, Albuquerque et al. 2020). Increased exuberance of investors for socially responsible companies would prompt even the most reluctant manager to go green, simply to increase market value. A greater interest in green companies would increase the price of their stocks leading to more environment-friendly investment and a positive impact on society.

Nevertheless, there is a need to exercise caution. Riding this exuberance, a green stock may enjoy better risk premium even with weaker fundamentals. Consequently, a speculative or intrinsic bubble might develop (Chakrabarti and Sen 2018). As the bubble bursts, the irrational exuberance may turn into irrational pessimism leading to significant withdrawal from the market. An exploration into the risk of investing in green stocks, is therefore essential.

The dynamics of market risk of Indian green stocks

Focussing on Indian green stocks, we examine the dynamics of their market risk. Investment in an asset comes with two types of risks: first is the unsystematic risk, which is unique or specific to the asset and second, the systematic or market risk that affects the entire market. While the unsystematic or idiosyncratic risks can be managed through proper portfolio diversification, the market risks cannot be. As a result, the risk-avert investors are more concerned about the latter and seek to choose resilient assets that are less susceptible to it. Hence, we focus on the market risks of green stocks and trace their evolution over time. Further, we assess whether such risks intensify as the domestic and global markets pass through different regimes of stress. This is crucial as escalating risk of an asset during market stress would diminish its resilience and consequently, undermine its appeal as a safe place for investment.

We use publicly available, daily data on BSE-GREENEX for the period from October 2008-January 2024. We choose BSE-SENSEX and NASDAQ Composite Index as proxies for domestic and global market, respectively. To measure the market risks of the green stock index, we construct its time-varying beta, which we shall henceforth call green time-varying beta (GTVB).¹ The benchmark value of beta is set at one when the stock resembles the market. A stock with a beta greater than one is marked as an ‘aggressive’ stock: the returns from such stocks respond more than proportionately to a given change in market return, which is detrimental in a falling market. Hence, aggressive stocks are inherently risky and risk-averse investors avoid them. ‘Defensive’ stocks, on the other hand, have beta less than one: their returns respond less than proportionately to the rise or fall in the market. Defensive stocks are considered safer and are typically preferred by risk-averse investors. Subsequent literature has suggested that the sensitivity of a stock’s return to market movements varies over time. Only a time-varying beta can capture the dynamics of market risks in a realistic and comprehensive way, and we have followed suit and used time-varying beta². We also define periods of stress in the local and global markets as phases where the current market return falls significantly below an average historical return³.

Indian GTVB moves between 0.8 and 1.18. It exceeded the benchmark value of one – that is, green stocks exhibited aggression – in the aftermath of the global financial crisis of 2007-08 as well as in three other turbulent phases. These were as follows: (i) from late-2011 to mid-2012 (ii) from late-2012 to mid-2013, and (iii) from 2016 to mid-2019. During the first phase, the international credit markets were under strain, economic growth was stalling, and apprehensions that the global economy could slide into a recession were escalating. The turmoil continued even in 2013 when European banks experienced financial pressure. On account of factors such as the Chinese market crash, OPEC (Organization of the Petroleum Exporting Countries) production slash, and Brexit and the consequent recession, 2016 was also earmarked as a year of financial meltdown. The financial markets, however remained stable and prospered during 2017-2019. The observed escalation in market risks of Indian green stocks during crises might raise concern about their desirability as a safe investment avenue. The recent trend however moderates the apprehension. A downward trend in GTVB was visible since late-2019 that continued through the Covid-19 pandemic. Risks fluctuated thereafter, but a decline has been visible since November 2023.

Figure 1. Movement in time-varying beta of Indian green stocks (2008-2024)

The ‘empirical survivor’ graph (Figure 2) shows the probability of obtaining a value of GTVB (shown on the horizontal axis), which is at least as great as a given value. Here, we check the probability of getting a GTVB value that is at least as great as one, which is the benchmark as discussed earlier. If the probability of getting GTVB greater than or equal to one is very high, the green stocks will be predominantly aggressive and risky. As is evident from Figure 2, probability of getting GTVB greater than or equal to one is low, even less than 40%. Thus, despite an occasional tendency of being aggressive (as shown in Figure 1), Indian green stocks are mostly defensive - in more than 60% of cases, to be precise.

Figure 2. Empirical survivor graph for Indian GTVB

Next, we examine the probability with which market risk of green stocks switches between different volatility regimes⁴. Specifically, we check if the GTVB starting in a particular volatility regime, remains there or moves into a different volatility regime. If initially the GTVBs are in a high-volatility regime and tend to persist there with all probability, the risks of investing in green stocks escalate. On the contrary, if they switch to a low-volatility regime, risk-averse investors benefit.

Persistence, however, is not always bad. If the GTVBs start from a low-volatility regime and persist there, the desirability of green stocks as safe place for investment increases significantly. Switching regime will not help the risk-averse investors in this case. We find that if initially the GTVBs are in a low-volatility regime, they tend to persist there 96% of the time. Conversely, if they begin in a high-volatility regime, there is an 82% probability of persistence. Further, a low-volatility regime is expected to last for 24 months while a high-volatility regime is expected to last for only five months. Moreover, as depicted in Figure 3, GTVBs have remained mostly in a low-volatility regime. During the period from October 2008 to June 2014, which includes the global financial crisis of 2008-09, GTVB remained in the low-volatility regime with all certainty. The impact of Covid-19 pandemic on GTVB was discernible only from January 2020 to July 2020 when the GTVBs switched to a high-volatility regime. Thereafter, they switched to a low-volatility regime and till date have remained there with all certainty.

Figure 3. Probability of GTVB to remain in low-volatility regime

Implications for investors

The findings are important for investors. The desirability of Indian green stocks lies in the fact that the volatility of their market risks hardly intensified during bad times. Market risks predominantly remained in the low-volatility regime and once there, risks were less likely to move into high-volatility regime. We concede that there is a tendency for the market risks to persist in a high-volatility regime, but a safeguard exists, which is that the expected duration of high-volatility regimes is quite low.

In a highly stressed domestic market, additional stress has no impact on GTVB. In a low-stress regime however, increased stress has an adverse but mild impact on GTVB that dampens over time. As stress rises in a low-stress regime, the investors anticipate an imminent shift to a high-stress regime and revise their expectations accordingly. As the market plummets, demand for green stocks (and thus, green returns) shrinks, but given the defensive nature of these stocks, the fall is less than proportionate. Hence, GTVB rises.

Expectations are revised further in the following days, but the consequent impact on GTVB is insignificant. In a high-stress regime, on the other hand, changes in market stress do not cause investors to revise expectations. As stress intensifies, investors do not expect additional stress to fall on GTVB. With their non-changing time-varying beta, green stocks act as hedging instruments in a high-stressed market. We further find that as the market passes through regimes of stress, additional stress has no impact on volatility of GTVB. The current volatility in GTVB is affected by its past volatility, rendering volatility of market risk to be ‘endogenous’ in nature.

Links between domestic and global markets

Moreover, with growing financial integration, a shock in the centre almost instantaneously transmits to the peripheries. The Indian market should be no exception. As stress intensifies globally, apprehension develops about domestic market. This may be self-fulfilling with impact on market risk and its volatility.

We find the market risks of Indian green stocks and their volatilities to be resilient in the face of global market stress. The stocks still act as a hedging instrument. Some might find it obvious as the betas are essentially domestic market betas. However, as noted earlier, risks transmit easily in financially integrated markets and hence, domestic betas may well be expected to vary across different regimes of stresses in the global market. What saves the Indian green stocks is perhaps the low degree of association between the Indian and the global market. This is evident from the time-varying correlation between returns in the two markets (Figure 4)⁵.

Figure 4. Conditional correlation between Indian and global market returns

While the findings establish the risk-resilient nature of the Indian green stocks, one should arrive at a conclusion with caution. Volatilities in market risks are endogenous to the system, determined exclusively by their past volatilities. External factors such as market movements or market stresses have no impact on them. This makes prediction and regulation of market risks difficult. Investors looking to invest in Indian green stocks need to take a closer look beyond their apparent resilience and understand this latent risk. An under-assessment of risk may lead to long-term losses, resulting in withdrawal of investment from the sector, defeating the sustainability objectives.

Notes:

The concept of beta comes from the Capital Asset Pricing Model (CAPM) of Treynor (1961), Sharpe (1964), Lintner (1965) and Mossin (1966). CAPM relates the systematic risk, or the general perils of investment, to the expected return, particularly from a stock. The CAPM beta (or, simply, the beta) indicates the sensitivity of a stock to market movements and is a measure of the undiversifiable market risk of investing in that stock.
The time-varying beta is constructed using a suitably lagged multivariate GARCH model.
We employed the CMAX method by Sarkar and Patel (2003)
We employed a Markov Regime Switching Model
We employed a Multivariate GARCH model to compute conditional correlation