Good stories lead to bubbles, and ESG is a good story

I have written in the past about how green stocks may develop into a bubble and how advisers think that green stocks are worth more than brown stocks. Since then, many renewable energy stocks have made substantial losses as supply chains got disrupted and the cost of raw materials has skyrocketed. As of today, I don’t think green stocks are in a bubble, but they are prone to getting into one again in the future simply because, well, it’s a positive story.

Many readers will be familiar with the lab experiments involving a simulated stock market where people trade with each other in an artificial asset. Typically, the asset pays a dividend in each round of the trading game but is worthless at the end of the game. This means that the fundamental value of this asset declines by the amount of dividend paid each round. Yet, when real people trade in such a market, they regularly trade shares at prices well above fundamental value and often create share price bubbles that then burst a few rounds before the game ends and the stocks become worthless.

Two researchers from LMU Munich repeated these experiments with 351 students using a twist. In each experimental market, nine randomly selected people were asked to trade with each other in the same stock with the same fundamental characteristics. Yet, in one third of the experiments, the participants were given ESG information that showed that the company is particularly good on the sustainability front, in one third of experiments the company was presented as particularly bad, and in the last third it was presented as neutral.

Most people get emotional benefits out of holding sustainable or green stocks, so they might be willing to pay more for these stocks than for stocks that do not come with such a positive story. Indeed, the chart below shows that on average, sustainable stocks traded at higher prices for longer and then crashed harder than stocks with a poor sustainability performance or neutral stocks.

Average share price of stocks with different ESG narratives

Source: Balbaa and Worch (2023)

On closer inspection, the researchers found that share prices were driven by both emotions and personal values. If more people who had personal social values that aligned with climate change and sustainability issues traded with each other, the price bubble was larger and lasted longer. Similarly, if more women were in the group, the price bubble was larger and lasted longer. This is not to say that women are worse investors. Quite the opposite, there is quite a lot of evidence that on average women have better performance than men. But it shows that women often have a set of values that are more aligned with sustainability issues than men and this, in turn, has implications for how they invest.

What this research shows once again is that narratives matter. A positive, emotionally uplifting narrative about a stock helps increase its share price while negative stories suppress share prices. Just look at the current AI boom and the share prices of stocks closely linked to this narrative.

By the way, if you think that this is an incentive to buy brown stocks with negative ESG credentials, I must disappoint you. While stocks with a negative ESG narrative did not crash as often and as hard as stocks with a positive ESG story, they consistently traded at lower valuations/prices. The only way to increase valuations for stocks with a negative story in the experiment would be to improve the ESG narrative and become more sustainable.