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Climate change is one of the key economic challenges of our time. Economists and public policy scholars increasingly agree on the merits of carbon taxes and/or tradable permits to ensure adequate pricing of carbon emissions at the international level. However, given the current practical and political challenges in implementing such policies, policy-makers are also exploring alternative strategies that can accelerate the transition to a low-carbon economy.

In the 2015 Paris Agreement, world leaders established “making financial flows consistent with a pathway towards low greenhouse gas emissions” (Article 2) as one main long-term objective. One way policy-makers are trying to achieve this is by improving the information available to investors about the climate impact of their investments. The success of such policies, however, relies on the twin assumptions that investors will respond to more transparency by demanding more climate-conscious products and that fund managers and other intermediaries will in turn shift their assets towards more climate-friendly holdings.

In Ceccarelli, Ramelli, and Wagner (2020), we investigate whether these assumptions hold, exploiting a quasi-experimental situation in the mutual funds industry.

In April 2018, the investment platform Morningstar introduced an eco-label for mutual funds, the Low Carbon Designation (LCD). This event represented an unexpected increase in the level of information available to investors on the climate performance of mutual funds. Using data for both European and US funds, we establish three key results.

First, we show that investors reward funds recognized as “climate-friendly”. Funds that were labeled as low-carbon at the end of April 2018 on average enjoyed a 24 basis points increase in their monthly net flows relative to conventional (not-low-carbon) funds. This is a sizable economic impact: When compounded over the 8 months from May through December 2018, this premium results in higher net flows of around USD 22 million for the average-sized (USD 1.1 billion) low-carbon fund in our sample. The effect is even stronger for European funds.

Second, we study how active mutual funds reacted to the revealed investor preferences and to the implicit incentives created by the LCD. Changes in culinary habits and trends inspire chefs worldwide to adapt their menus to the new preferences of their clients. Similarly, with the chefs of the financial industry, investors' call for a low-carbon diet in their portfolios did not fall on deaf ears: Mutual funds that initially did not receive the LCD subsequently reduced (increased) their holdings in high (low) carbon-intensity companies. In other words, the incentives created by the release of the LCD accelerated climate-related investment strategies in the mutual fund industry.

However, the competitive response of mutual fund managers, tilting portfolios towards more climate-responsible investments, may reduce risk diversification. Our third result shows that LCD funds have higher idiosyncratic volatility than non-LCD funds. Hence, during the transition to a low-carbon economy, investors may face a trade-off between choosing LCD funds and diversification of their portfolios.

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