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 U.N.'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 the research also finds that the growth of such reserves is associated with lower valuations, a trend that cuts against the carbon bubble view. And when the authors dig deeper into the data, they find many clues that markets are pricing carbon risks in more meaningful ways.
For example, when reserves are divided into "developed" (which can be extracted from existing wells) or "undeveloped" (which generally require new wells), 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."
Atanasova and Schwartz also find evidence that the adverse effects on valuation are caused disproportionately by companies with high extraction costs (thus making it less likely they will yield sufficient future returns to justify their costs) and for reserves located in countries with tougher climate policies (which would likely reduce the future returns).
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 that the market puts lower value on, and requires higher returns from, companies with higher levels and growth rates of emissions. They also conclude that the market started to require significantly more compensation for climate risk after the Paris Agreement.
Interestingly, both studies conclude that institutional investors are not driving the markets' recent climate-related penalties. Despite the heightened attention to the issue among such investors, Atanasova and Schwartz find no material effect from institutional investors on the size of the climate penalty associated with undeveloped reserves. Similarly, Bolton and Kacperczyk find that divestment effects from large investors do not generally explain carbon risk pricing patterns. Such divestment tends to occur only in certain industries (such as oil and gas) and to be associated only with a narrow definition of emissions (so-called Scope 1, or direct, 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 penalizing 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.