Carbon Tail Risk, Ilhan et al. (2021)

ABSTRACT

• Strong regulatory actions are needed to combat climate change, but climate policy uncertainty makes it difficult for investors to quantify the impact of future climate regulation. We show that such uncertainty is priced in the option market. The cost of option protection against downside tail risks is larger for firms with more carbon-intense business models. For carbon-intense firms, the cost of protection against downside tail risk is magnified at times when the public’s attention to climate change spikes, and it decreased after the election of climate change skeptic President Trump.

Research target

• Utilize options market to price climate policy uncertainty

Methodology

• Downside tail risk is measured by the steepness of the implied volatility slope

• Implied skewness as a proxy of the expensiveness of protection against left tail event relative to the right

• Variance risk premium is measured by difference btw risk neutral expected and realized variance

• Regress each risk type by carbon emission, the interaction of carbon emission and event, pre versus post Trump election, etc.

Data

• Carbon emission: CDP - Carbon Disclosure Project, covering $87 trillion in AUM in 2018

• Scope 1 - direct emission, 2 - indirect emission from electricity or steam consumption, 3 - emission occur in firm value chain.

• Carbon emission is highly skewed and cluster in a few industries. Use carbon intensity - log(Scope X/MV firm) - in analysis.

• Options data: OptionMetrices, IV from OTM calls and puts with maturity of 30 days and delta of 0.5.

• Return and market capitalization data: CRSP

• S&P 500 firms participated in CDP from 2009 to 2016

Findings

• Strong evidence that climate policy uncertainty is priced in the options market.

• Sector ETF evidence: The cost of option protection against downside tail risks is higher for more carbon-intensive sectors of the S&P 500.

• Firm-level evidence: Options on carbon-intensive firms are more expensive, especially for far-left tail region.

• Time-series fluctuation: Cost of option protection against downside tail risk magnifies at times when public attention to climate change spikes. Goole index of "climate change".

• One-time shock: Cost of option protection against downside tail risk declines when climate policy uncertainty is reduced, Trump election 2016.

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