Measuring Firm Environmental Performance to Inform Asset Management and Standardized Disclosure

Investing according to environmental, social, and governance (ESG) criteria is gaining momentum. Most environmental performance indices focus only on the tonnage of carbon dioxide (CO₂) emissions. This paper proposes an index covering eight pollutants expressed in monetary damage. Inclusion of multiple pollutants reflects a broader range of reputational and regulatory risks. Monetization appropriately weights emissions. CO₂ dominates the mass of other pollutants, yet the marginal damages from other pollutants are larger than CO₂. In the U.S. utility sector from 2014 to 2017, indices which only track CO₂ mischaracterize firms’ environmental performance and underestimate its effect on financial outcomes relative to the multipollutant index. Dirtier firms exhibit lower share prices and higher forward returns. The effect is twice as large for the multipollutant index compared to CO₂. Analysts’ earnings forecasts for dirtier firms systematically undershoot actuals. Earnings errors are between three and five times more sensitive to the multipollutant index than to CO₂. The multipollutant index may suggest new management strategies to financial market participants relative to those based on carbon intensity. ESG disclosure standards based on the new index are more likely to affect financial outcomes, capital allocation decisions, and firm behavior than disclosure of carbon intensity.