The Connection Between Oil Prices, Stock Volatility, and Green Investments

Amid increasing social attention on sustainability, green investments are drawing interest. Green investments inject money into firms producing and supporting eco-friendly goods and services. For instance, the MSCI Global Environment Index, a stock price index of firms that generate at least half of their revenues from eco-friendly products and services, has earned more than 10% annualized return on average during the last decade. It outperforms the return of the MSCI World Index, a benchmark index of stock prices in developed countries.

When investing in green assets, risk management of a portfolio is critical. If all the assets in a portfolio move in the same direction as the equities of eco-friendly companies, the portfolio manager loses a large portion of assets in the decline of stock prices of green industries. By contrast, if the asset manager incorporates assets into their portfolio whose price is negatively correlated with the stock price of eco-friendly firms, she could offset the loss and stabilize the returns of the portfolio even during a plunge in the value of green assets.

Crude oil price is a key factor in assessing the risk of green investments. Generally, environmentally beneficial goods and services — many of which do not use fossil fuels — are seen as a substitute for oil-related products. Therefore, with a rise in oil prices, for instance, the demand for renewable energy and carbon-free goods increases because consuming petroleum products gets more expensive and vice-versa.

A recently published paper by Dutta et al. examines the relationship between the returns of green investments and the development of oil prices. In calculating the returns of green investments, the authors use two recently introduced environmental indices: the aforementioned MSCI Global Environment Index and the MSCI Global Green Building Index, which capture the performances of companies developing green infrastructure. Moreover, as a proxy representing the development of oil prices, they adopt WTI crude oil prices and Cboe Crude Oil ETF Volatility Index. The OVX is an index of implied volatility, which measures the market participants’ forecast of how much global oil prices swing in the future. The data had been recorded on a daily basis from September 2010 to December 2018.

According to the quantitative analyses by the authors, there is a negative linkage between the returns of green investment and the volatility of oil prices. It indicates that the stock-prices of eco-friendly companies move in the opposite direction to the volatility of crude oil prices. In other words, when the uncertainty of crude oil prices increases, green investments become unbeneficial, and vice-versa. The intuitive explanation for this connection might be that when the uncertainty of oil prices is high, crude oil prices usually decline because investors do not hold crude oil whose price is likely to fluctuate unexpectedly. The decline of oil prices disincentivizes people and companies to purchase alternate goods and services, hence a fall in profit for eco-friendly firms and investment withdrawals from them. As a result, an increase in oil price volatility might bring about the underperformance of the investment in green industries.

Relative to previous literature, this research is novel mainly in two respects. Firstly, the authors adopt the recently introduced stock price indices to measure the return of green investments. These indices enable them to capture the performance of a broader range of eco-friendly companies than before because earlier studies generally focus on the stock price of only clean energy firms. Moreover, the researchers include the volatility as well as the oil prices in the indicator of the crude oil market although many of the preceding papers examine only oil price fluctuations. As a result, they find that the return of green investments is responsive to oil market volatility rather than the variation of oil prices.

Their finding has great significance for asset managers and administrators of the public pension funds, which are recently piling up green assets as one part of the sustainable investments. This implies that by combining green assets with an oil volatility index such as the OVX, the asset managers can hedge the risk of the price decline in green assets since they move in opposite directions. For example, even if the stock prices of eco-friendly firms plunge, the rise of the OVX can offset it and vice-versa. As a result, such a hedging strategy could help the portfolio generate stable returns.

Dutta, Anupam, R.K. Jana, and Debojyoti Das. 2020. “Do green investments react to oil price shocks? Implications for sustainable development.” Journal of Cleaner Production 266, 121956. https://doi.org/10.1016/j.jclepro.2020.121956.