Investors do care about firms' regulated carbon emissions

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. 

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).