Foundations of Climate Investing: How Equity Markets Have Priced Climate-Transition Risks

Abstract

Countries have set varying targets to reduce greenhouse gas emissions in line with the Paris Agreement’s goal of keeping the increase in global average temperatures to well below 2°C. In this article, the authors examine to what extent climate risk has been priced into equity markets and whether climate change can be modeled using a typical risk model structure. They develop the fundamental economic transmission channels to explain the potential impact of climate change on equity prices, including empirical evidence for climate policies and green technology as financial risk drivers. They also study the impact of climate-transition risk on valuation levels and trends. They conclude with a discussion of how to measure and categorize companies’ climate-risk exposures and how to integrate climate-transition risks into risk models. <b>TOPICS:</b>ESG investing, security analysis and valuation, tail risks <b>Key Findings</b> ▪ The authors identified economic transmission channels showing how regulatory policies and green technology influence financial markets. In developed markets outside the United States, more carbon-efficient companies experienced stronger performance over a seven-year study period. They found companies’ green revenue share was clearly associated with higher earnings growth and relatively better stock performance within a given sector. ▪ Next, they looked at the relationship between companies’ climate-transition risk profiles and their valuation levels, finding that carbon-intensive companies experienced declining valuation in terms of price-to-book ratios than their less carbon-intensive sector peers—suggesting that markets have discounted the book value of carbon-intensive companies during the study period. In contrast, companies with significant green revenues saw their price-to-earnings ratios increase relative to their sector peers. ▪ Companies’ earnings growth and stock performance was directly related to their greenhouse gas emissions. Using five MSCI low carbon transition categories, the authors found that the riskiest category (stranded assets) had the weakest performance and the solutions category the strongest during the study period. Although most performance differences were explained by the industry factor, there was a significant stock-specific return that showed a strong correlation to companies’ climate transition-risk profile.