By Patrick Bolton, Columbia Business School and Marcin Kacperczyk, Imperial College London
Public opinion, governments, business leaders, and institutional investors all over the world are awakening to the urgency of combatting climate change. This growing concern could cause a faster and more disorderly transition away from fossil fuels to renewable energy. In turn, companies will face greater carbon-transition risk, especially those that rely more on fossil fuel production or consumption.
Transition risk captures the uncertain rate of adjustment towards carbon neutrality for individual companies, and also embodies the evolving beliefs about the transition to a greener economy among investors. It is caused by a wide range of shocks, including changes in climate policy, reputational impacts, shifts in market preferences and norms, and technological innovation.
In our study we evaluate the economic importance investors attach to this, by looking at stock returns for more than 14,000 publicly listed companies in 77 countries with different degrees of exposure to transition risk. Overall, it paints a nuanced picture of carbon-transition risk pricing around the world, revealing that pricing is uneven across countries but widespread in North America, Asia, and Europe.
How is transition risk priced globally?
Two theories lend themselves to the global pricing of transition risk. One is that as financial markets are globally integrated, the same climate change risk in China or New York is priced the same way. The other is that financial markets are substantially segmented, so that carbon risk pricing in each country also reflects local conditions. We find that markets are at least partially segmented.
Investors in companies that supply fossil fuel energy, and in companies that rely on this energy for their operations, are increasingly exposed to risk with respect to policies seeking to curb carbon emissions and to technological risk from alternative, more affordable, renewable energy. Using firm-level carbon emission and financial data we quantify the carbon premium – that is, the return that compensates investors for taking on this carbon-transition risk, other things equal.
If carbon-transition risk is overlooked there would be no significant correlation between stock returns and CO2 emissions (once all other known risk factors and firm characteristics are controlled for). Yet, we find that carbon emissions do affect stock returns in most areas of the world.
The premium is economically sizable with respect to direct emissions (scope 1), indirect emissions from consumption of purchased electricity, heat, or steam (scope 2), and other indirect emissions from the production of purchased materials, product use, waste disposal, outsourced activities, etc. (scope 3). Both the total level of CO2 emissions produced by companies and their year-by-year emissions changes matter. The former measure can be understood as a long-term risk projection, given that emissions are highly persistent, while the latter is a short-term risk projection.
We explore which factors carbon premia are associated with across countries, industries, and firms, and discover several interesting patterns in the data. The first is that economic development levels do not explain cross-country variations in the carbon premium. However, several other country characteristics matter: voice (how democratic political institutions are) and rule of law significantly affect the carbon premium associated with emissions changes.
More democratic countries with stronger rule of law tend to have lower carbon premia, other things equal. One possible interpretation of this is that in these countries pressure from green public opinion has already resulted in significant tightening carbon emissions regulations, so that the transition risk going forward is lower. Several other findings support this. We find that the carbon premium is lower in countries with a higher share of renewable energy, and higher in countries with larger oil, gas, and coal extracting sectors. Firms located in countries with tighter domestic (but not international) climate policies exhibit a higher long-term return premium. Surprisingly, firms in countries that have been exposed to greater damages from climate disasters (floods, wild-fires, droughts, etc.) do not show a markedly different carbon premium associated with direct emission levels.
Given that climate change has only recently become a salient issue for investors, we also explore how the carbon premium globally has changed, by comparing the estimated premia for the two years leading up to the Paris Agreement and following it. Several striking results emerge. When we pool all countries together, we find that there was no significant premium before the Paris Agreement, but a highly significant and large premium in the years following it. This is consistent with the view that investors have only recently become aware of the urgency of climate change. When we break down this change by continent, we find that it is insignificant in North America before and after Paris, has declined in Europe, but has sharply risen in Asia. In effect, Asia is entirely responsible for the rise in the global carbon premium around following the introduction of the Paris Agreement.
Our study is relevant for debates around carbon taxation. Carbon taxes have been touted as the policy solution for mitigating climate change. Yet, in practice (global) carbon taxation has met significant political opposition. Considering this reality, our study suggests an alternative (complementary) approach via financial markets. The increasing cost of equity for companies with higher emissions can be viewed as another form of carbon taxation by investors seeking compensation for carbon-transition risk.
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