ESCP ALUMNI magazine - #201 - Mars 2023 - 52

Campus ❙ Brèves
Research highlight
Investors do care about firms' regulated carbon emissions
Premature deaths due to air pollution cost the global economy about
$225 billion in lost labour income, and more than $5 trillion in welfare
losses worldwide in 2013, according to a joint study of the World
Bank and the Institute for Health Metrics and Evaluation. This figure
is equivalent to the combined GDP of India, Canada and Mexico.
Yet despite this " sobering wake-up call " (the World Bank's terms),
firms appear to behave as if they had little incentive to internalise
the cost associated with their impact on the natural environment.
While policies and regulations do exist to compel companies to
clean up their act, they vary across countries and over time. Even the
European Union's Emissions Trading System (EU ETS), which is the
first and largest mandatory international system of its kind, started
in 2005 with generous allocations of free permits before gradually
transiting to auctions for carbon emission quotas. By reducing the
total number of EU allowances (EUA) - the amount of carbon credits
put out on the market - on an annual basis, this cap-and-trade system
is meant to provide a simple incentive for companies to decarbonize
their operations. It's the well-known polluters-pays principle: you
want to emit greenhouse gases, you reach for your wallet.
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.
Firms that emit more than their industry peers (...), on average, trade
at discount of 37.5%, while firms that emit less than their industry
peers, on average, trade at fair value.
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).
Incentives to decarbonize operations
Do these findings mean that financial markets do not encourage
companies to make more than a minimal effort to curb emissions?
Not quite, since the study finds that the predictive power of emissions
vanishes in the group of firms that invest in clean technology. The
researchers also note that " firms that emit more than their industry
peers (...), on average, trade at discount of 37.5%, while firms that
emit less than their industry peers, on average, trade at fair value. "
So high-emission firms do have an incentive to decarbonize operations,
as investors do reward firms' credible perceived commitment
to the environment. Policymakers may therefore be well advised to
promote the development of green technologies and improve the
disclosure framework of climate-related information. Finally, the
researchers suggest one more application for policymakers who wish
to further enlist markets in their fight against a major factor of climate
change: to take actions to improve stock market liquidity, given that
insufficient liquidity seems to create a barrier for investor divestment.
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ESCP Alumni Magazine numéro 201 ❙ MARS 2023
ESCP ALUMNI magazine - #201 - Mars 2023

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