Research Highlight Investors do care about firms' regulated carbon emissions

A cornerstone of the EU's climate policy is its carbon trading scheme. In effect, it creates a new type of climate risk for the companies concerned, with potential effects on their market value. But how much do investors care? A new study examines how stock markets respond to companies' efforts to limit their carbon emissions and suggests ways to further enlist investors in the fight against climate change. 

Premature deaths due to air pollution cost the global economy about $225 billion in lost labour income, and more than $5 trillion in welfare losses worldwide in 2013, according to a joint study of the World Bank and the Institute for Health Metrics and Evaluation. 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), firms appear to behave as if they had little incentive to internalise the cost associated with their impact on the natural environment.

While policies and regulations do exist to compel companies to clean up their act, 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, started 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 decarbonize their operations. It's the well-known polluters-pays principle: you want to emit greenhouse gases, you reach for your wallet.

Why markets may want to price climate

But what happens when your “wallet” is a large amount of capital owned in part by shareholders? In a 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 which needs to be priced?

This question of how financial markets handle the extra cost associated with carbon emissions is the subject of a new research paper by Houdou Basse Mama and Rahel Mandaroux. They explain that companies operating with emissions constraints 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 the uncertain future cost of emitting carbon dioxide,” they write. 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

So the duo of researchers set out to examine the asset pricing implications of companies' carbon emissions under the EU ETS system. While previous research has relied on voluntary disclosure or estimates of carbon emissions, or covered just one country, their study used actual emissions (TVE for total verified emissions), their sample spanned a wide period, from 2005 to 2017, and was distributed across 15 industries and 18 countries. 
The authors constructed three portfolios - “clean”, “medium” and “dirty” - based on the carbon emission measures of the sample firms, and matched emissions data and number of allocated emission permits (EUA) with firm-level financial information. 

The researchers posited that carbon emissions shared an inverted U-shape relation with firm valuation. “While carbon pricing transforms emissions into privately internalized costs, industrial pollution is considered an 'unavoidable' by-product of normal production, leading policymakers to set 'acceptable' levels of emissions (caps),” they write. 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. 

Firms that emit more than their industry peers (…), on average, trade at discount of 37.5%, while firms that emit less than their industry peers, on average, trade at fair value.

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,” detail the researchers. The result would likely be a willingness on the part of investors to choose environmentally neutral firms over “toxic” or “green” firms. 

Indeed, the study confirmed the expected U-shape relation between CO2 emissions and 1-year-ahead market valuations, with a valuation that increased with emissions, then decreased beyond a certain threshold. Specifically, the study's portfolio tests indicated that the annualized 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 decarbonize 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 study finds that the predictive power of emissions vanishes in the group of firms that invest in clean technology. The researchers also note that “firms that emit more than their industry peers (…), on average, trade at discount of 37.5%, while firms that emit less than their industry peers, on average, trade at fair value.” 

So high-emission firms do have an incentive to decarbonize operations, as investors do reward firms' credible perceived commitment to the environment. Policymakers may therefore be well advised to promote the development of green technologies and improve the disclosure framework of climate-related information. Finally, the researchers 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. 


Houdou Basse Mama - ESCP Business School Houdou Basse Mama Professor of Finance at ESCP Business School (Berlin campus), where he holds the Chair in International Financial Markets.
Rahel Mandaroux Rahel Mandaroux PhD candidate at ESCP Business School (Berlin campus), and Lecturer at The Berlin School of Economics and Law.