Markets are putting a price on climate risks

Climate specialists have warned for years about a “carbon bubble” in which markets ignore or massively undervalue the risks to companies from climate change. Two new studies suggest, however, that financial markets have started seriously pricing carbon risk, especially since the Paris Agreement of 2015.
Whatever its other effects, that agreement may thus go down in history as the beginning of the end for any carbon bubble. With policymakers meeting in Madrid this week for the UN’s annual climate conference, the new research should provide some comfort that their actions will be reflected in financial market prices.
One of the new studies, by Christina Atanasova of Simon Fraser University and Eduardo Schwartz of the University of California, Los Angeles, examines North American oil producers. In a sample of almost 700 oil companies, they find that, after controlling for multiple other factors, stock market values are higher for producers with larger reserves. This would be consistent with the carbon bubble perspective.
But research finds the growth of such reserves is associated with lower valuations, a trend that cuts against the carbon bubble view.
For example, when reserves are divided into “developed” or “undeveloped”, the developed reserves raise stock values but undeveloped reserves reduce them. This pattern is what one would expect if markets are awakening to climate risks, the authors note, suggesting the possibility that “future oil reserves that are generated from current capital expenditures will most likely remain in the ground.” The take-away: “market participants recognize, at least partially, that these investments are potentially negative NPV [net present value] projects that will destroy firm value.”
In addition, the negative effect of reserve growth on valuations has been much stronger after the Paris Agreement than it was before. If the agreement helped to awaken markets to climate risks, this difference would make sense.
The other recent analysis, by Patrick Bolton of Columbia Business School and Marcin Kacperczyk of Imperial College London, assesses a wider array of companies, numbering more than 3,000, that extend well beyond the oil industry. The title of their paper is “Do Investors Care about Carbon Risk?” Their answer is “largely consistent with the view that investors are pricing in a carbon risk premium at the firm level.” The authors find the market puts lower value on, and requires higher returns from, companies with higher levels and growth rates of emissions.
The new studies together suggest that markets are distinguishing among companies based on climate risks in significant ways, and that the effects have been notably larger since the 2015 Paris Agreement. The most extreme version of the carbon bubble, in which carbon risks are ignored by markets altogether, is thus no longer an accurate picture of how stocks are priced.
What is not clear from either study, however, is whether the market is penalising future climate exposure sufficiently to reflect the risks. In other words, what if the magnitude of how financial markets price climate risks still underestimates the actual future risks? In that case, some carbon bubble effects would persist.
What is clear is that climate risks will continue to increase over time. It’s also clear, based on the latest research, that the market will respond to those risks.
—Bloomberg