One of the things that I keep thinking about in the ESG investing space is what the UN calls the inevitable policy response. In short, if we accept the fact that the climate is changing (and if you don’t you should stop reading this post and educate yourself on the science because there is absolutely no doubt that climate change is real) then we have to adapt our economy to this change. The costs of adapting to climate change are going to be huge and one cornerstone to finance climate change adaptation is going to be to put a price on carbon.
There are many different ways to put a price on carbon but my personal favourite remains a cap-and-trade scheme where the government sells a limited amount of rights to emit CO2 to businesses who can then choose to emit CO2 or reduce CO2 emissions and sell their rights to other companies. A cap-and-trade scheme has the advantage that it turns an externality into an internality and puts a price on carbon so that financial markets can figure out the best allocation of a scarce resource. In short, a cap-and-trade scheme lets the market take care of climate change rather than a central government.
Cap-and-trade schemes and other carbon emission schemes have been introduced around the world and by 2020 about 20% of global CO2 emissions will be subject to carbon emission schemes. The biggest scheme so far is the European Emissions Trading Scheme launched in 2005 and covering 2 billion tonnes of CO2 emissions per year. China is currently covering more than 1 billion tonnes of CO2 emissions per year but is on its way to launching the world’s biggest emission trading scheme.
Global emissions schemes
Today, most of the existing emission schemes charge about $10 to $25 per ton of CO2, but the general consensus is that in order to achieve the goals of the Paris Climate Accord, the price has to increase towards $100 per ton of CO2.
What matters, of course, is the path to this goal. We can choose to start at low prices for carbon and then gradually increase the cost of carbon to give businesses time to adjust, yet still achieve our goal to mitigate climate change and raise funds to finance adaptation. Or we can decide to not introduce carbon schemes and wait until the last minute at which point, we have to suddenly raise a lot of capital – creating a systemic shock to the economy as Bank of England Governor Mark Carney warned. Note, that our choice is not if, but when. We will have to foot the bill for climate change eventually. All we can do is choose to pay it in instalments starting today or as a lump sum when the bill comes due.
The impact a sudden increase in the price of carbon has on stocks of different companies has recently been investigated by Steffano Carattini from Yale and Suphi Sen from the Ifo Institute. They looked at two ballot initiatives in the state of Washington in the US.
Initiative I-732 would have introduced a carbon tax of $15 per ton of CO2 for all emissions in the state of Washington. The tax would have gradually risen to $100 per ton of CO2. The carbon tax would have been offset by a reduction in sales taxes and other measures to make the tax fiscally neutral and not a burden on businesses. Nevertheless, the initiative was rejected at the ballot box with 59% of the votes despite opinion polls indicating a victory of the initiative.
In 2018, the people of Washington state rejected I-1631 with an initial carbon tax of $15 per ton of CO2 increasing towards $100. However, this time, the measure would not have been fiscally neutral but instead the revenues from the tax would have been earmarked to fund environmental and social projects in the state. In effect, this was as close to a Green New Deal initiative as one can come these days. Again, the initiative seemed on its way to being approved but suffered a last-minute swing against it and eventually was defeated at the ballot box with 57% of the votes.
What makes these two initiatives such great case studies is that they were similar in nature though different in impact to local businesses and in both cases the public perception was that they would be accepted at the ballot box but then suffered a surprise defeat. This means that the share prices of companies based in Washington state had to suddenly readjust to the news that no carbon tax was going to be introduced. And indeed, especially after the rejection of I-1631, the authors of the study find a material jump in share price of companies based in the state of Washington of around 2% within ten trading days (Note that these returns are abnormal returns that are corrected for industry effects, as well as fundamental variables like the profitability and the valuation of stocks).
Financial markets were quite efficient in their reaction to the failed initiatives insofar as they differentiated between companies with high CO2 emissions and companies with low CO2 emissions. As the chart below, taken from their analysis, shows the average abnormal return of a company with above average CO2 emissions was about 4% in the three days after the ballot initiative failed while low carbon emitters only rallied by about 1%. The error bars in the chart below show the 95% confidence interval and reveal that the reaction of low carbon emitters was indistinguishable from zero, while there was a statistically significant rally in high emitters.
Abnormal price reaction to failed carbon tax initiative I-1631
Source: Carattini and Sen (2019).
So here you have the price reaction of stocks in reaction to a gradual carbon tax scheme. Now imagine what would happen to the share price of these stocks if a carbon tax would be introduced all over the US? Of course, high carbon emitters such as energy and utility companies would see their share prices drop relative to low carbon emitters. But if we introduce a low carbon tax today that increases over time the price reaction is moderate and not too extreme.
Now imagine we do not introduce such a carbon pricing scheme but instead wait until we face the bill whenever it comes due. At that point we might need to introduce a carbon tax of $100 per ton of CO2 from one day to the next. Guess what that is going to do with the share prices of carbon intensive companies? To me, investing in carbon intensive companies looks like a greater fool’s game. They might perform well for a long time, but at some point, some investors will be stuck with shares that have become nearly worthless. Will you be the one who owns these shares then?