Many companies view climate change as a risk to their products, operations, and supply chains. But the rise of renewable energy, electric vehicles, and net-zero homes illustrates the opportunities for businesses willing to jump into sustainability.
What if we see climate change as an engine of innovation and growth through new products and services?
“What if we see climate change as an engine of innovation and growth through new products and services?” asks George Serafeim, the Charles M. Williams Professor of Business Administration at Harvard Business School.
While the promise of sustainability might sound alluring, regulatory uncertainty and fickle consumers have made some companies reluctant to invest in climate solutions. There’s currently no easy way to measure the impact of such ventures: Gauges of carbon emissions only consider the direct effects of companies’ sustainable business practices, not the wider impact of green products nor their financial outcomes.
“A battery producer might, if anything, incur more emissions in their operation over time,” says Shirley Lu, assistant professor at HBS. “But those batteries are powering lower emissions elsewhere.”
Serafeim, Lu, and colleagues at the Climate and Sustainability Impact Lab at the Digital Data Design (D^3) Institute at Harvard set out in early 2023 to harness generative artificial intelligence (AI) to probe the interplay of climate, innovation, financial analysis, and strategic management. They developed a new model that analyzes companies’ annual reports to understand how firms engage with climate-related innovations.
Over a series of working papers, the team found that:
Incumbent companies that are launching sustainable products and services increase revenue faster than companies that aren’t stepping into the green economy.
The revenue growth potential of firms successfully commercializing these solutions makes them attractive investments to portfolio managers trying to hedge against the climate-transition risks of their other holdings.
The ChatGPT of climate solutions
Serafeim and fellow researchers focused on public companies’ 10-K filings—annual reports required by the US Securities and Exchange Commission. Companies are held accountable to the information in the statements, which captures all aspects of a business in a standardized format.
“It’s a legal document, so it’s reliable—you don’t have the cheap talk you find on websites or other less-regulated forms of disclosure,” Serafeim says. “If you’re not generating solar energy, you can’t just say you are.”
The team, which includes HBS Postdoctoral Fellow Simon Xu, used data from more than 35,000 annual filings from 2005 to 2022 to create their own large language model (LLM), essentially a specialized version of ChatGPT. The model uses natural language processing to identify nearly 100 climate solutions that companies might engage in, along with their relative importance in a company’s product portfolio.
So this GPT can really understand what a climate solution actually is, rather than just a statement like ‘We commit to being climate friendly.'
“We fed the model about 3,500 sentences, which we picked from the most confusing sentences representing climate solutions,” Lu explains. “So this GPT can really understand what a climate solution actually is, rather than just a statement like ‘We commit to being climate friendly.’”
Using the model, the researchers measured the percentage of sentences that represent real opportunities for the environment in each report, ranking them against those of other firms. The model categorized sentences by type of solution, enabling researchers to augment the data with the characteristics of each solution, such as its carbon reduction potential and associated costs.
“We are building a whole new asset in the D^3 lab and creating data that can answer many questions at once,” Serafeim says.
Solutions as a ‘lever for growth’
In the working paper “The Financial Anatomy of Climate Solutions,” Lu and Serafeim used their generative AI tool to compare “pure” companies, whose product portfolio focuses primarily on climate solutions—such as Tesla and Impossible Foods—and “transition” companies, incumbents that are shifting toward climate solutions. General Motors, a transition company, is phasing out internal combustion–based cars in favor of electric vehicles, for example.
The team found that transition companies had a unique competitive advantage:
Their revenue rose 1.7 percent faster than those of comparable companies that hadn’t added sustainable products to their portfolio.
While pure companies seemed to grow revenue faster at 5.4 percent, their edge vanished when matched up with companies of similar size and age that aren’t focusing on climate solutions. Pure companies tended to be younger and smaller.
The authors found an exception to their findings among pure firms in industries that have embraced climate solutions, such as producers of cars, energy, and batteries. In those industries, pure firms increased revenue by 3.8 percent, compared with companies with few climate solutions in their product portfolios.
“The fact that there are more climate solutions suggests these sectors have more demand,” leading to more growth, says Lu.
On the other hand, the researchers noted that growth comes with a cost—higher expenses for research and development (R&D), specialized talent, and cost of materials that result in lower profitability for higher climate solution firms.
“There’s growth, but it’s not coming for free,” Lu says. In fact, the solutions most likely to drive down emissions created the highest revenue growth—but also the highest capital expenditures.
Serafeim says the new goods and services of transition firms may create a “corporate renewal” effect that boosts revenue. They also show higher profitability sooner compared with pure firms, as they’re able to spread out the higher costs of goods and R&D with their other product lines.
“Climate solutions provide a lever for growth, making a boring, old company an exciting place for people to work,” Serafeim says.
In contrast, pure firms initially show lower profitability on average, due to the higher costs of goods and investment in research and development. Over time, however, the researchers found that that profitability margin increases as they achieve economy of scale and spend less on R&D as a proportion of their sales, leading to greater profitability in the end.
“In the short and intermediate term, profitability is going to be painful,” Serafeim says. “The question for those firms is, how do you buy patience?”
Hedging against transition risk
Another working paper, “Climate Solutions, Transition Risk, and Stock Returns,” coauthored with Boston University Professor Edward Riedl—examined the stock performance of these companies. The researchers found that firms offering more climate solutions delivered lower stock returns, leading to higher valuation multiples, such as their price-to-book value or price-to-earnings ratio, as investors likely bought those shares to hedge against climate risks. If there were to be a regulatory change, such as taxing carbon emissions at a higher rate or providing financial incentives to install heat pumps, those companies would benefit, while more traditional companies would suffer.
“Heat pumps might grow in sales, but furnaces would be losing,” Serafeim says. “So those companies act as a hedge for you, and are therefore more valuable, and have higher prices.”
When climate policy-related shocks occur, the researchers found that sustainability-related stocks outperformed their counterparts that were less focused on climate solutions:
Around the signing of the Paris Agreement on climate change, shares of climate solutions-focused companies rose 6 percent, relative to the returns of companies less focused on climate solutions.
When President Joe Biden was elected, they jumped 3.4 percent.
They surged 8 percent after the announcement of the Inflation Reduction Act.
“It goes back to this idea of corporate renewal,” Serafeim says. “When you are developing these products and services, it can not only drive revenue growth, but also affect your valuation in the market.”
When incumbents learn from startups
While this project may be the first to be able to demonstrate these effects scientifically, the market seems to already be getting that message. In a third working paper, “Catalysts for Climate Solutions,” the team found that larger incumbent firms are taking their cues from smaller startups. When venture capital investments focus on climate-tech startups within a certain industry, they found that larger firms within that industry also increase their focus on climate solutions.
“If the venture capitalists have a preference for climate tech, or a track record of doing well, then the incumbent firms react even more strongly,” says Xu. “And if the deals have more media coverage and attention in terms of new investors coming on board, it’s even more pronounced.”
On the other hand, if the deals include a high number of impact investors, who prioritize environmental impact over profits, then industry stalwarts react less strongly, implying that their motivation for action is a belief that climate solutions will lead to higher profits overall.
“It’s a signaling story,” Serafeim says. “The transition firms are learning from what is happening in the entrepreneurial space, seeing the viability of these products. Rather than saying, ‘Oh no, this is going to destroy our business,’ they are fighting back and accelerating their own transition into those solutions.”
While Serafeim and the other researchers are just getting started in applying these innovative new techniques to examining climate tech, initial results are promising. The analyses show that developing climate solutions provides significant opportunities for both new and existing companies.
“It can be challenging and require you to invest more, and, in the short term, your gain may not be as great,” Serafeim says. “But the question becomes, ‘How do you transform the organization to accelerate growth, realize those economies of scale, and move to a very competitive position?’”
