Flight to climate: liquidity commonality in brown equities

Abstract: Emerging ESG studies have established a negative equilibrium correlation between ESG factors and stock returns in an economy predominately influenced by investors with nonpecuniary preference over high ESG credentials. However, little research has delved into a potential systematic liquidity risk phenomenon associated with aggregate trading activities of ESG-motivated investors who share a common nonzero ESG preference component in their utility function. Focusing on the carbon footprint metric of ESG factors, this thesis aims to investigate the potential existence of an ESG-specific component in liquidity commonality among equities listed on Nasdaq Stockholm, with a key assumption being that the average investor active on the Swedish equity market is cognizant of emission data and willing to forgo financial returns for positive externalities. Using a calibrated portfolio sorting technique and a set of time series regression models, the thesis uncovers novel evidence of liquidity synchronicity among ESG-unfavorable stocks. Additionally, the results indicate that liquidity dynamics of ESG frontrunners tend to be reflective of firm level characteristics. These findings remain robust even after controlling for market-wide driving forces, industry effects, and nonsynchronous liquidity co-movements etc. Investors prioritizing climate efforts may have tilted their capital away from emission laggards which give rise to a “flight to climate” effect on stock liquidity synchronicity among brown equities. Their resultant constrained investor base may lead to simultaneous liquidity oscillation as observed. Notwithstanding, the thesis does not measure explicit mechanisms through which ESG factors impact stock liquidity commonality, leaving this as a topic for future research.