Green Sentiment, Stock Returns, and Corporate Behavior

In this paper, we propose a new method to estimate non-fundamental demand shocks for green financial assets based on the arbitrage activity of exchange-traded funds (ETFs). By estimating the monthly abnormal flows into environment-friendly ETFs, we construct a Green Sentiment Index that captures shifts in investors' appetite for environmental responsibility that are not yet priced in the value of the underlying assets. Our measure of green sentiment differs significantly from the news-based climate indexes proposed by the extant literature, and it has additional explanatory power on both stock returns and corporate decisions. Over the period 2010-2020, shifts in green sentiment anticipate a persistent stock-price out-performance of more environmentally responsible firms, (of approximately 53 basis points over six months for a one-standard-deviation higher green sentiment) as well as an increase in their capital investments and cash holdings, particularly for more equity-dependent ones.