Is the financial sector sufficient to timely shift the transition of the global economy with respect to the intertemporal carbon budget constraint we are bound to, as computed by IAM models, and described in the latest IPCC report?
This study, once established the historical relationship of carbon emissions in the European bourses, punctuates the level of care of investors with respect to the environmental economic externalities, comparing obtained results to past flourishing green and socially responsible literature. It investigates which could be the direct translation of the given premium into a so-called shadow price of carbon emissions CO2 equivalent, as of the difference in historical discounted cash flows listed companies are on average paying in Europe for emitting CO2 emissions equivalent today.
It ought to be trivial and intuitive how the climate change existential threat is boiled down to an energy supply problem and consumer standard of living behavior,
A couple of following emblematic examples perfectly picture the paradoxical society we are living in today. One of the most renown investors alive, Berkshire Hathaway CEO’s Warren Buffet, has publicly stated how “energy deregulation will be the largest transfer of wealth in history”.
An important piece of the puzzle is the relative difficulty in translating IPCC estimation reports into quantifiable, uncertain, measures of future risks. Sustainable and Green Finance Academic Research aim to shed some light on how investors are navigating this uncertain financial and economic environment which gradually and heterogeneously prices carbon emissions. Albeit there is still an important degree of uncertainty concerning climate-related financial risk models, the GHG protocol provides investees and investors an internationally recognized methodology to account emissions’ scopes and hence monitor and compare them.
An econometric approach to quantify the carbon premium of European markets so far
An incremental asset-pricing literature addresses the fundamental question of whether carbon emissions currently affect financial security prices, particularly stock and fixed income markets in the past five to seven years. Previously to Cop21, scarce economic or extra-financial data was available to account for carbon risk exposures within investors’ portfolios. Since Cop21, several leading pioneers, such as the Church of England Pension Fund, are engaging within the boards of shareholders, asking for commitments to curb CO2 equivalent emissions and disclosure of such pledges and targets.
Measuring the historical carbon risk
The choice of panel regression as econometric methodology over alternatives, namely portfolio studies and event studies (see Ambec and Lanoine, 2008) is justified when accounting for unobserved company heterogeneity and other omitted variables biases (Horváthová, 2010) and when counting for relevant literature published in Financial Economic Journals. Based on economic theory, it makes it easier to draw plausible causal conclusions. I adopt a fixed-effects model with year-fixed effects and estimating it using robust standard errors clustered at the firm level. Robustness test is performed changing the battery of control variables, and checking for a premium before and after 2015, the year of the entrance of Paris Agreement. The cross-sectional panel is declined within 2010-2020 timeframe, comprising of 738 unique identifiers from MSCI Europe and STOXX 600 indexes.
For all three categories of emissions, we relate in turn the level of companies’ emissions, the year- to- year growth in emissions, and the companies’ emission intensity to their corresponding stock returns in the cross-section. I first estimate the following cross-sectional regression model using pooled OLS:
RET i,t = a0 +aı LOG(TOTEmissions) i,t + a Controls i,t-ı +μt +e i,t
where RET measures the stock return of company i in month t and Emissions is a generic term alternately standing for SCOPE 1, SCOPE 2, and SCOPE 3 emissions. The vector of controls includes a host of firm-specific variables known to predict returns, such as LOGSIZE, B/M, ROE, LEVERAGE, MOM, INVEST/A, HHI, LOGPPE, BETA. Our model also includes year/month fixed effects. We cluster standard errors at the firm and year levels. The coefficient of interest is a1.
Results confirm the initial hypothesis of a positive carbon premium for the Total GHG absolute emissions at the 5 % level. Every unit increase in GHG total emissions raises financial returns by 1,23 % historically and annually. All coefficients of the control variables have the anticipated sign and are largely statistically significant in the regressions. Thus, results might be interpreted as a growing investor preference for low – instead of high-carbon assets as their increased perception of risk of high emitting stocks. All variables are confirmed to be statistically significant and economically significant in explaining historical financial returns.
Limitations
Some control variables, such as HHI, INVEST/A and ROE, have been computed manually following well-known corporate finance definitions. BETA was not available on Eikon prior 2014. C, PPE, SIZE, LEVERAGE insignificance is common in renown and recognised international academic papers such as Bolton 2020. Hence, the model is still valuable if its robustness is checked. Only a single source of data and no multiple/cross validation have been pursued. It is missing the heteroskedasticity test to fully validate the model. Further sectorial analysis would be useful to better understand the EU ETS financial impact on the portfolio’s public companies.
Shadow carbon price
As a result of the carbon premium encountered historically, through the certainty equivalent principle it is possible to derive an average historical shadow price implied in financial markets as a result of equivalent expected cash flow asked to firms polluting more than the market average to pay throughout the years. The calculation is showed here-below :
The intuition: Cf/(1+Ck0 + p) = (Cf –pE)/(1+Ck0)
where
Cf: firm’s annual cashflow (€)
Ck0: cost of capital without carbon premium p: carbon premium
P: shadow price per emission ton (euros) – the variable unknown
E: absolute emissions (tons of CO2 equivalent)
The shadow carbon price equals to € per ton of CO2 equivalent. For the European average historical cost of capital, cash flow and emissions, results equal to an average of 0,39 € per ton of CO2 equivalent of the panel.
In conclusion, Climate-related risks are becoming an increasing source of concern in financial markets. This research supports and further investigates the evidence on GHG emissions, a crucial indication of environmental damage, and investors' positive premium as a result of increased absolute, growth and intensity GHG emissions. The key conclusion is that enterprises with higher emissions typically reflect higher market returns, and the relative measure, carbon intensity, is significant too, signaling investors’ integration of those measure within portfolio management practices. The findings are compatible with previous literature (Chava 2014, Trinks and al. 2017, Bolton 2020) who discovered too a positive relation between carbon emissions and financial stock returns or cost of equity or again estimating the relation using a forward-looking PE valuation model.
