Climate-change risks can result from physical forces like wildfires, floods, or droughts or from changes in policy, the so-called transition risks created by government actions or the adoption of new technologies. A key question for academics, policy makers, firms, and investors is whether either type is being priced into securities markets.
In a new paper, Dissecting Climate Risks: Are they Reflected in Stock Prices?, we provide an answer to that question. We analyze climate news and provide separate proxies for market-wide physical risks and transition risks by performing textual analysis of Reuters climate-change news over 2000-2018.
We find that climate risks stem from four broad sources: natural disasters, global warming, international summits, and U.S. climate-policy news. The latter includes presidential addresses, election results affected by climate news, debates over legal reforms, the enactment of laws, and appointments to key regulators such as the Environmental Protection Agency. We document that only imminent U.S. climate-policy risks are accounted for in U.S. stock prices (investors require an average return of from 0.30 percent to 0.59 percent per month once other risks are considered). This result is most pronounced after November 2012, spanning the second Obama administration and the Trump administration. We verify this finding by constructing a narrative U.S. climate-policy factor based on 3,500 news articles. Increases (decreases) in this factor signal an increase (decrease) in transition risks. Figure 1 shows the changes in our narrative factor over time. The pattern reveals a reduction in transition risks post-November 2012. In November 2012, the Democratic Party lost a majority in the House of Representatives, and in November 2014 it also lost a majority in the Senate. Over this period, the news reveals the inability of President Obama to tackle climate change, which is reflected in the observed pattern of our variable. The period starting in November 2016 covers the Trump administration, which was characterized by a pronounced fall in transition risks.
Figure 1: Faccini, Matin and Skiadopoulos (2021) Narrative U.S. Climate Policy factor
Source: Faccini et al. (2021), Dissecting Climate Risks: Are they Reflected in Stock Prices?
We find that stocks that are more exposed to climate risks, that is, stocks that lose value when climate risks rise, pay a higher returns on average than stocks that are less exposed. We propose the hedging of transition risks as an economic explanation for the documented U.S. climate-policy risk premium. To insure against climate risk, investors buy the stocks whose returns tend to increase on average when climate risks rise, pushing their prices up and their average returns down, relative to the prices and average returns of risky stocks. We validate our explanation with a series of tests. Interestingly, in contrast to what one would expect, we find that investors do not necessarily invest in “green” firms to hedge climate-policy risk. Instead, they hedge by investing in firms that display a strong intention to become environmentally friendly, as indicated by the change in their environmental score. Interestingly, these stocks are used as a hedging instrument even if the firms’ current environmental score is low; previous research has documented that some of the most polluting businesses in the U.S. are key innovators, producing more, and significantly higher quality, green patents. Even though the change in environmental scores captures more than just green innovation, our finding indicates that the market recognizes the disconnect between current environmental scores and intentions to improve these scores, at least when it comes to hedging policy risks.
Our findings reveal that the risks generated by government intervention, not the direct risks from climate change, are priced into the stock market. There are several possible explanations for this One is that investors start paying attention to climate risks only when they become an issue in U.S. politics. A second possibility is that investors lack information on the exposure of businesses to all sources of climate risk. This view seems to be shared by several institutions and financial regulators and is inspiring new regulation on the disclosure of climate risks. A third possibility is that financial investors are myopic in that they are only focused on risks that have immediate financial effects. All three explanations imply that climate risks are mispriced, in line with the view shared by a number of policy makers. According to this view, policy intervention is required to address the market failure underlying the mispricing.
Finally, a very different potential explanation for our results is that climate change per se does not pose a material financial risk, and hence it is not expected to be priced into the markets. In contrast, any government intervention is expected to be priced, yet it can threaten financial stability by stranding assets and hurting firms’ profitability. Disentangling these different views is beyond the scope of our study, but it is arguably one of the most pressing questions facing climate research.
This post comes to us from Renato Faccini and Rastin Matin at Danmarks Nationalbank and from George Skiadopoulos at the University of Piraeus and Queen Mary University of London. It is based on their recent article, “Dissecting Climate Risks: Are they Reflected in Stock Prices?” available here.