ET.20.008 – How blue is CO2? Politics and the pricing of carbon risk

Route: Energy transition

Cluster question: 019 How should we undertake the transition to an entirely sustainable energy supply?

International policy efforts to curb CO2 emissions suggest that investors should consider carbon risk in their evaluations. It is not clear, however, whether financial markets price this risk correctly. The empirical evidence is scarce in this respect. A young and growing literature seems to be divided on whether carbon emissions command a risk premium (Bolton and Kacperczyk, 2019, 2020), or represent a source of mispricing (In et al., 2019).

In this project, we analyze this issue from a political perspective. Climate change represents a major talking point in modern politics, creating substantial controversy along party lines. In the U.S., for example, Democrats argue that climate change exists and should be tackled by limiting CO2 emissions, whereas Republicans believe that there is not enough evidence to warrant such intervention. Democratic presidencies are then more likely to introduce stringent CO2 regulations, which negatively affects carbon-inefficient firms.

Since political affiliation affects economic evaluations (see, e.g., Gerber and Huber, 2009; Mian et al., 2017), acting as a perceptual screen (Campbell et al., 1960), this political division may also affect investors’ evaluations. If some investors neglect carbon risk, carbon-efficient firms would face a higher cost of capital (see, e.g., Montone et al., 2019), especially under Democratic administrations.

We also identify two potential moderating effects. First, regulatory risk should be lower when government is divided, as the two parties mutually obstruct each other (Alesina and Rosenthal, 1995, 1996; Coleman, 1999). Second, the controversial nature of CO2 regulations makes them less likely to be introduced when the administration has less political capital, such as when the president’s popularity is low, or political polarization is high.

Overall, political division over carbon emissions may create a perverse incentive for U.S. companies to shun green investments. We expect to find a similar effect also for European companies.
Persons involved: Maurizio Montone – Utrecht University (UU)

Keywords

Carbon risk, Investor disagreement, Return predictability.

Other organisations

Utrecht University (UU)

Submitter

Organisation VU Amsterdam (VU), Utrecht University (UU)
Name Prof. dr. R. (Remco) Zwinkels
E-mail r.zwinkels@vu.nl
Website https://research.vu.nl/en/persons/remco-zwinkels