Brown coal mining and wind turbines

Monthly Report: How climate policy influences equity prices

CO2 prices and pathways of greenhouse gas emissions in selected screnarios
In the latest Monthly Report, the Bundesbank’s economists examine how climate action impacts the equity prices of stock corporations. Using projections from a climate model developed by the Potsdam Institute for Climate Impact Research, they compare the effects of a scenario that is in line with the Paris Agreement climate targets (consistent with global warming of 1.5°C between 1850-1900 and 2100) with the consequences of an implementation of the end-of-2020 pledges, or Nationally Determined Contributions (consistent with global warming of 2.4°C). In the underlying climate model, the price of carbon emissions is the key climate policy lever. It is initially assumed that, at the current juncture, the financial markets expect implementation of the Nationally Determined Contributions.[1] The next step is to compare current equity prices with prices after market expectations have switched to the Paris-aligned scenario cited above.

As outlined in the report, the 5,285 stock corporations included in the analyses are domiciled in 75 countries from various regions of the world, where their businesses are subject to the prevailing national climate policies. Together they account for more than half of global stock market capitalisation and are responsible for 17-20% of global greenhouse gas emissions. For the calculations, the companies – and the emissions they account for – were each assigned to one of twelve regions based on where the parent company is headquartered.

Large proportion of stock corporations suffers only small losses

The result of their analyses: given Paris-aligned decarbonisation and a correspondingly sharp rise in carbon prices, a large number of the companies under review can expect only small emissions-related equity price losses. At the same time, more than one-tenth of capitalisation – €4.7 trillion or 15% of all companies – suffers losses of more than 50% of the company’s value, the economists write. Meanwhile, 78% of the total market capitalisation is left unscathed by emissions-related share price losses of more than 4%.

Those stock corporations whose remaining greenhouse gas emissions cause them high costs in relation to their expected dividends, in particular, suffer large losses in value. Companies whose business activities are centred around fossil fuels will be strongly affected, the Bundesbank explains. “They may face the risk of stranding even if they reduce emissions in compliance with the Paris Agreement,” so the report. An asset is said to be stranded prior to the end of its useful economic life – as expected at the time of investment – if it can no longer yield any economic return and thus loses its entire value.

Emissions-related price impact indicator in a sectoral breakdown
The results outlined apply to the case where companies are unable to pass the incremental costs of the remaining greenhouse gas emissions following Paris-aligned decarbonisation on to the consumer. In this case, the emissions costs incurred will reduce profits in the full amount and consequently dividends as well. If, however, companies are able to pass through 80% of their costs, just 7% of all companies would experience losses of more than half the enterprise value.

Regional carbon price is key

Distribution of stock corporations' valuation effects
In sectoral terms, the Bundesbank’s economists see the highest potential emissions-related equity price risk from the shift in expectations as described above with airlines and in the coal, cement and steel industry. By contrast, they believe the potential losses of market capitalisation to be comparatively low in the automotive industry, in manufacturing, services, and in construction and engineering. Alongside the dividends expected for the individual companies and their current greenhouse gas emissions, the carbon price pathway in the respective region is key to the emissions-related change in the value of the company. In conjunction with projected greenhouse gas emissions, it determines how the costs that the company incurs in this context develop in the climate scenario under review.

Climate-related valuation changes and the question of climate-related stranding of certain assets are therefore likely to play an important role in the financial markets going forward,” the Bundesbank writes. With regard to “green” structural change or the transition to a low-carbon economy, stranding of certain business models may, however, be essential if the goal is the efficient use of funds for necessary investment in financial markets.

Footnotes:

  1. This is already a more optimistic assumption regarding today’s market expectations than the assumption that the markets currently simply expect “business as usual” to continue.