Carbon Risk: Do financial markets really care?

By Fabrizio Ferraro |  Professor and Head of the Strategic Management Department at IESE Business School

"Climate risk is investment risk," stated Larry Fink, Chairman and CEO of BlackRock, in his January 2020's letter to CEOs. This statement was met with both excitement and skepticism in the business community. This knowledge pill builds on recent academic research in finance to introduce the concept of climate transition risk and explore whether investors are already considering it in their decisions.

To mitigate the effect of climate change, 196 countries signed in 2015 the Paris Agreement, a legally binding international treaty to limit the temperature increase well below 2°C and preferably below 1,5°C. To reach this goal, Carbon Dioxide (CO₂) and other greenhouse gases emissions will have to be cut dramatically (a global emission decrease of 7,6% per year). As a comparison, consider that when COVID-19 lockdown policies brought most societies to a halt in 2020, CO₂ emissions dropped 5,4%. Furthermore, as the Carbon Tracking NGO recently showed, even adding up all the public and private 2030 targets, we would be on track for a 2,4°C increase by the end of the century. This gap opens the door for future policy tightening, requiring deeper cuts in emissions.

What does it all mean for the investors?

The financial community considers two types of climate change risks that will affect corporations and their investors: physical and transition. While physical risk is important, it is difficult to capture at the corporate level, and this pill will focus solely on transition risk. Climate transition risk refers to the consequences firms and investors will face as countries accelerate the adoption and implementation of policies to cut CO₂ emissions. This includes cuts required by current policies and the ones due to novel ones. This risk is likely to be higher for corporations with higher emissions and those more emission-intensive. But are investors considering this risk in their decisions, or in other words, are financial markets pricing carbon risk?

In two groundbreaking studies, Patrick Bolton (Columbia University) and Marcin Kacperczyk (Imperial College) showed that a global carbon-transition premium does exist and is economically meaningful. They argue that this premium can be measured by showing the correlation between stock returns and the CO₂ emissions of a firm. The idea is that if investors are considering emissions as a risk factor, they are likely to demand a carbon risk premium to hold stocks of corporations with higher emissions. Thus these stocks would exhibit a higher return.

This premium is related to both direct emissions (scope 1) and indirect emissions (scope 2 and 3). Overall, a one-standard-deviation increase in the level of scope 1 emission (an increase of 2,95 tons of CO₂ emissions) for a firm is associated with a 3,61% increase in its stock returns (and thus a 3,61% annual carbon risk premium). This premium has almost doubled since the signature of the 2015 Paris Agreement.

The study also shows that while the premium exists in Europe, North America, and Asia, it is not statistically significant in Africa, Australia, and South America, suggesting investors in these parts of the world have not started integrating carbon risk in their valuations.

In sum, financial markets seem to have started to consider climate risk as a risk factor in their investments. Interestingly the higher returns of high emissions stocks might also be an opportunity for short-term-oriented investors. Nevertheless, their short-term gains might be swept away by the "inevitable policy response" that governments will take as the temperature keeps going up.

You can find the full knowledge pill here for a more detailed analysis.