Global CO2 emissions, which contribute to greenhouse gas emissions and global warming, rebounded to their highest level ever in 2021 due to the increased use of coal. Premature deaths due to air pollution also cost the global economy about $225 billion in lost labour income and more than $5 trillion in welfare losses in 2013.
This figure is equivalent to the combined GDP of India, Canada and Mexico. Yet, despite this “sobering wake-up call” (the World Bank’s terms), many firms appear to behave as if they had little incentive to internalise the cost associated with their impact on the natural environment.
Image: The Cost of Air Pollution: Strengthening the economic case for action, a joint study of the World Bank and the Institute for Health Metrics and Evaluation (IHME)
While policies and regulations do exist to compel companies to clean up their acts, they vary across countries and over time. Even the European Union’s Emissions Trading System (EU ETS), which is the first and largest mandatory international system of its kind, began in 2005 with generous allocations of free permits before gradually transiting to auctions for carbon emission quotas.
By reducing the total number of EU allowances (EUA) – the amount of carbon credits put out on the market – on an annual basis, this cap-and-trade system is meant to provide a simple incentive for companies to decarbonise their operations. It’s the well-known polluters-pay principle: if you want to emit greenhouse gases, you reach for your wallet.
Why markets may want to price climate risk
But, what happens when your ‘wallet’ is a large amount of capital owned in part by shareholders? In the context of growing environmental consciousness, are investors still willing to put their money in ‘dirty’ industries with costly externalities? As ESG (environmental, social and governance) aspects are more and more often factored into financial analysis, perhaps investors view carbon emissions as a material risk that needs to be priced?
This question of how financial markets handle the extra cost associated with carbon emissions is the subject of our research paper. We explain that companies operating in emissions-constrained environments face several climate risks that potentially have negative effects on firm value. Regulatory climate risks stem from policies and regulations in place to fight climate change and concern about the uncertain future cost of emitting CO2.
In addition, technological transition climate risks relate to the risk of technology obsolescence driven by the necessity of the transition to a low-carbon economy. Between financiers pricing in uncertainty about the future cost of emissions and the more environmentally-minded funds ‘greening’ their portfolios, high-emitting firms are likely to trade at a discount on the stock market and/or to need to offer higher returns to attract takers.
Examining the market valuations and returns of polluting firms in the EU
We set out to examine the asset pricing implications of companies’ carbon emissions under the EU ETS. While previous research relied on voluntary disclosure or estimates of carbon emissions or covered just one country, our study used actual emissions – Total Verified Emissions (TVE). Our sample spanned a wide period, from 2005 to 2017, and was distributed across 15 industries and 18 countries. We constructed three portfolios – ‘clean,’ ‘medium’ and ‘dirty’ – based on the carbon emission measures of the sample firms and we matched emissions data and the number of allocated emission permits (EUA) with firm-level financial information.
We posited that carbon emissions shared an inverted U-shape relation with firm valuation. While carbon pricing transforms emissions into privately internalised costs, industrial pollution is considered an ‘unavoidable’ by-product of normal production, leading policymakers to set ‘acceptable’ levels of emissions (caps). After all, it’s unlikely that companies regulated under the EU ETS, which includes airlines, power plants and energy-intensive industries such as cement factories or refineries, could ever reduce their carbon emissions to zero.
Also, firms that seek to maximize shareholder value have an incentive to abate emissions (and future environmental liabilities) by engaging in climate risk management – up to a point. Institutional investors may consider corporate environmental practices beyond legal requirements as a mere drain on corporate resources that could otherwise be invested profitably. The result would likely be a willingness on the part of investors to choose environmentally neutral firms over ‘toxic’ or ‘green’ firms.
Indeed, our study confirmed the expected U-shaped relation between CO2 emissions and 1-year-ahead market valuations with a valuation that increased with emissions, then decreased beyond a certain threshold. Specifically, our study’s portfolio tests indicated that the annualised abnormal return was substantially larger for the medium portfolio than for the clean or dirty one (respective Sharpe ratios – a reference risk-adjusted performance measure – were respectively 0.47, 0.19 and 0.12).
Incentives to decarbonise operations
Do these findings mean that financial markets do not encourage companies to make more than a minimal effort to curb emissions? Not quite, since the predictive power of emissions vanishes in the group of firms that invest in clean technology. Firms that emit more than their industry peers, on average, trade at a discount of 37.5%, while firms that emit less than their industry peers trade at fair value on average.
Therefore, high-emission firms do have a strong incentive to decarbonise operations, as investors do reward firms’ credible perceived commitment to the environment. To that extent, policymakers may be well advised to promote the development of green technologies and improve the disclosure framework of climate-related information. Finally, we suggest one more application for policymakers who wish to further enlist markets in their fight against a major factor of climate change: to take actions to improve stock market liquidity, given that insufficient liquidity seems to create a barrier for investor divestment.