Article pollution premium Flashcards
The authors test their main hypothesis using both Portfolio sorts and Fama-MacBeth methods. Briefly describe both methods and the unique contributions of each in the context of this particular study. Briefly explain your answers. (4 points) (PART 1)
Do the portfolio sorts
The portfolio sorts method splits the sample into some number of groups based on the variable in question (in this case, 5 portfolios based on emission intensity). The authors use univariate portfolio sorts to show that the highest emitting firms have higher returns than the lowest emitting firms. Further, the authors use double-sorts to rule out dependence of the pollution premium on other variables (such as firm size, as discussed in question Xa).
The authors test their main hypothesis using both Portfolio sorts and Fama-MacBeth methods. Briefly describe both methods and the unique contributions of each in the context of this particular study. Briefly explain your answers. (4 points) (PART 2)
Do the Fama macbeth
The Fama-MacBeth method regresses involves (2nd stage) cross-sectional regressions of returns on the key variable alongside other variables that one would expect to predict returns. Fama-MacBeth may or may not include a first stage in which time-series regressions are run to estimate the betas (risk loadings) of individual firms or portfolios with respect to one or more risk factors, but in this paper no such betas were included in the 2nd stage, so no 1st stage was necessary. The paper just reports results of 2nd stage cross-sectional regressions of excess stock returns on emissions as well as a number of other firm characteristics in other to determine the “price” (or “gamma”) of these characteristics in the cross-section of returns. Compared to sorts, this method allows the authors to test for the pollution premium across all levels of emission intensity as opposed to just the top and bottom
5ths quintiles. Further, Fama-Macbeth regressions allow the authors to control for several other potential characteristics (or risk loadings) to more effectively isolate the effect of emission intensity on stock returns.
Justify the existence of a “pollution premium” as a systematic risk factor. What are the two main alternative explanations of “anomalies” like this? Briefly explain your answers. (4 points)
Pollution is risky for individual firms since their profitability may be hurt if government policies are imposed to reduce pollution. Those firms that do not have high emissions will not be as affected by any (constricting) change in environmental regulations, while more heavily polluting firms may be exposed to a higher probability of litigation. If a new government policy that would punish high-emission firms more harshly were to be enacted, high-emission firms would more likely either have to adjust their operations to reduce emissions or face the threat of litigation. Both of these cases would likely have a negative impact on firm cash flows, which would ultimately reduce their price and increase their expected return. While emission intensity varies by firm, government policies will likely apply to many (if not all) firms in many industries, so it may well be a systematic source of risk that cannot be easily diversified.
The two other main alternative explanations for such anomalies are that they (i) may be a statistical fluke (i.e., not robust), which is hard to judge based on one paper alone, or (ii) that they are driven by mispricing. Mispricing in this case would mean that polluting firms are underpriced relative to “clean” firms and that limits to arbitrage would prevent correcting the mispricing.
What could be reasons why higher toxic emmision stocks would outperform (alternative hypotheses)
Firms with high toxic emissions may be subject to protests, litigation, and reputation risk (price goes down, return goes up)
High emission firms may deploy more obsolete cpaital as they invest in less advanced production capital
retail investors may overreact to negative emission news and sell at deep discounts
what methods are used in the pollution paper
Portfolio sort (univariate on emission intensity and double sorting on emissions and size)
Fama macbeth regressions
Industry fixed effects (controlling for industry)
What is the ‘Mechanism’ and what is the mechanism of the pollution paper
How does this happen (polution driving returns)
Answer: Regime change risk (there is a risk that pollution will be punished by the government which will have a negative impact on the Cashflow, either by changing or by lawsuits which is driving the current price down)
What is the difference between Fama Mac Beth regression an univariate sort
- Multifactor approach (fama macbeth can incorporate multiple factors to explain differences)
- Combines both time series and cross sectional information. where univariate only uses cross sectoinal data.
How is emission intensity defined in the pollution paper?
ratio of toxic emissions related to total assets
How to know if a coefficent is economically significant
It is important to know the know dependent variable for example if it is in billions and it changes 1 it is not economically significant but if it is in thousands it would be
We can adjust for this by using the St.dev. so a 1 st.dev shock in x has a ? st.dev shock on y.
We do this by multiplying the slope (effect of x on y) by the st.dev of the independent variable (x) and dividing it by the stdev of the dependent variable y
if it is monthly we times it by 12 both the stdev of y as the stdev of x
Explain the obsolete capital alternative hypothesis
High-emission firms may deploy more obsolete capital as they invest in less advanced production capital
-> New technology shocks will require them to update their production capital -> CF are sensitive to technology shocks old/cheap capital (obsolete) -> hurt when tech advances -> prices down – ex return up
High-emission firms employ more obsolete technology as they invest less in advanced production capital. The arrival of new technology forces these firms to upgrade their production capital, and hence their cash flows are likely sensitive to frontier technology shocks
Explain the retail investor alternative hypothesis
retail investors may overreact to negative emission news and sell at deep discounts
->This would push the price of high-pollution firms down and thus push their returns up
Maybe high polution firms -> subject bias from retail investors -> selling their holdings more than supposed to be -> prices down
Possible limitation: is there enough power behind retail investors They made a measure that measure proportional institutional and retail investors
In contrast to institutional investors who are more rational and have more complete information, retail investors may be subject to greater behavioral
bias . For example, retail investors may panic in response to negative emission news and sell all their stock holdings at deep discounts. If such overreaction explains the pollution premium, we would expect the emission-return relation to exist only among stocks that experience a significant drop in the share of retail investors
How could the recent trend of green investing cause the pollution premium
Invest less in polluting fimrs more green -> lower price brown firms -> increase expected (r)
Explain the financial constraints alternative hypothesis
high-emission firms may be subject to financial constraints due to litigation and penalties related to environmental issues.
Give a brief overview of the methodology (3 steps)
mention: One-way Portfolio Sorts, Fama-MacBeth Regressions, Double Sorting
The steps you’ve outlined for the methodology of the “Pollution Premium” paper are essentially accurate. Here is a concise overview of the methodology:
- One-way Portfolio Sorts: The paper uses one-way portfolio sorts to demonstrate that emissions positively predict stock returns and that this relation is robust to known systematic risk factors.
- Fama-MacBeth Regressions: The authors employ Fama-MacBeth regressions to investigate whether other firm characteristics can explain away the positive relationship between emissions and stock returns.
- Double Sorting: Double sorting on size and emissions is conducted to confirm that the observed “pollution premium” is not merely driven by the size effect.
Each step is designed to test and ensure that the positive correlation between emissions and stock returns is not confounded by other variables and to strengthen the claim that there is a distinct pollution premium.
