Idiosyncratic volatility positively explains the excess returns of clean energy stocks

RISC Principal Scholar Professor Perry Sadorsky co-leads a study that reveals the inherent dynamics of the clean energy sector

Dr. Perry Sadorsky

Idiosyncratic risk in clean energy stocks must be fairly priced. In fact, numerous studies have confirmed that it is the idiosyncratic risk that drives the stock return’s predictability against the ubiquitous Capital Asset Pricing Model (CAPM), which only accounts for the systematic risk, assuming that the non-systematic (idiosyncratic) risk is well-diversified. The importance of idiosyncratic risk is not surprising as investors are not free from psychological biases and act on the grounds of morality, representativeness, and affect heuristics based on “good” or “bad” quality of investment leading to irritational judgment. Nevertheless, in the clean energy finance literature, detailed firm-level investigations that can reveal the inherent dynamics of idiosyncratic risk are lacking.

In their paper entitled "What do we know about the idiosyncratic risk of clean energy equities?" and published in Energy Economics, Professor Perry Sadorsky and coauthors provide a detailed overview of the impact of idiosyncratic risk on excess returns of 95 clean energy stocks. The researchers conclude that idiosyncratic volatility and excess returns of clean energy stocks are positively correlated, besides during the COVID-19 period, during which no significant relation is observed. The findings confirm that investor heterogeneity and market irrationality exist in the clean energy sector and establish a link between an economic downturn and contraction of clean energy investment.