Carbon Risk, Gorgen et al. (2019)

ABSTRACT

• We investigate carbon risk in global equity prices. We develop a measure of carbon risk using industry standard databases and study return differences between brown and green firms. We observe two opposing effects: Brown firms are associated with higher average returns, while decreases in the greenness of firms are associated with lower announcement returns. We construct a carbon risk factor-mimicking portfolio to understand carbon risk through the lens of a factor-based asset pricing model. While carbon risk explains systematic return variation well, we do not find evidence of a carbon risk premium. We show that this may be the case because of: (1) the opposing price movements of brown firms and firms becoming greener, and (2) that carbon risk is associated with unpriced cash-flow changes rather than priced discount-rate changes. We extend our analysis to different geographic regions and time periods to confirm the missing risk premium.

Research target

• Quantify carbon risk by construction of "Brown-Minus-Green" portfolio

Methodology

• Construct "Brown-Minus-Green" (BMG) portfolio by sorting "Brown-Green-Score" (BGS)

• Incorporate BMG intro asset pricing model as a new factor, analyze BMG coefficient (carbon beta) across countries, industries, etc.

• Investigate explanation of carbon betas - Innovation in clean technology and stranded asset

• BGS is determined by value chain (production & supply chain that generate emission), adaptability (ability to adapt to changes in transition process), and public perception.

Notes

• Climate change threatens human beings. The world has agreed on the transition from a brown, high-carbon economy to a green, low-carbon one.

• How fast this transition will be and which path it will take is uncertain. Uncertainty in policy, regulation, and technology are referred to as "Carbon Risk".

• If carbon risk is a risk factor, it's possible to develop a factor-mimicking portfolio that isolates this exposure. Develop the "Brown-Minus-Green portfolio (BMG)" and add it to common asset pricing models.

• Conjecture :
  Green firms' equity will respond positively to unexpected changes towards a low-carbon economy.

  negative; Green firms' equity has a negative BMG coefficient (carbon beta), meaning greener equities benefit more from carbon risk exposure.

• Construction of BMG by BGS, BMG increases the explanatory power of the asset pricing model.

• Carbon betas vary across countries, negative in EU & Japan, positive in Canada, Brazil...

• Carbon betas vary across industries, positive for energy & material industries

• Carbon betas vary within industries, which indicates carbon risk is not a simple proxy for certain industries.

• Investors can achieve lower carbon risk exposure without sacrificing risk-return performance.

  Firms investing in innovation & clean tech, measured by R&D expenditure, have lower carbon betas. Firms with dirty or "stranded" assets, proxied by PPE assets, have higher carbon betas.

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