Do investors care about carbon risk?

( Patrick Bolton and Marcin Kacperczyk)

(Journal of Financial Economics, 2021)

Presented by:Sohail Raza 223227071

Date: 01-05-2023
DBS, Deakin University, Australia.

1/19
Introduction (Background)

Two major developments in the climate finance research,

1 The Paris COP 21 climate agreement of December 2015 with 195

signatories committing to limit global warming to well below 2
degrees Celsius above pre industry levels.
2 The rising engagement of the finance industry with climate change,
which leads to,
a Institutional investors are increasingly tracking the GHG emissions of
the listed firms.
b Forming coalitions such as climate action 100+ to engage with
companies to reduce their carbon emissions.
In the light of these developments, one would expect to see the risk
with the respect to carbon emissions to be reflected in the cross-
section of stock returns.

2/19
Theoretical Motivation

Yet considerable skepticism about the carbon emission remains

among the companies and investors that might not be reflected in the
asset prices.

This leads the authors to explore,

Whether investors demand a carbon risk premium by looking at how
stock returns vary with Carbon emission across firms and industries
in US.
Also, incorporating corporate carbon emission risk in analysing the
cross-sectional pattern of stock returns has been missing out as the
concern about climate change and carbon emissions have become
salient recently.
3/19
Theoretical Framework

Several ways to expect carbon emission affects stock returns.

1. Carbon emissions are tied to fossil-fuel energy use, returns are

affected by fossil-fuel energy prices and commodity price risk.

2. Firms with disproportionately high carbon emission maybe exposed

to carbon pricing risk and other regulatory interventions.

3. Firms rely on fossil energy are exhibiting technology risk from

lower-cost renewable energy.

Carbon premium, therefore is defined as the excessive return

associated with the brown firms (Firms that are more carbon
sensitive).

4/19
Related Literature

1. Krueger, Sautner, and Starks (2020) argued that the institutional

investors believe climate risks have financial implications for their
portfolio firms and that these risks, particularly regulatory risks,
already have begun to materialize.
• Using their implications, the authors also form a research question
that reflect the relationship between institutional investors and
carbon premium.
2. In et al. (2019) on a different sample than this study finds that a
portfolio that is long stocks of companies with low carbon emissions
and short stocks of companies with high emissions generates positive
abnormal returns (Market inefficiency or carbon Alpha Hypothesis).
3. Hong and Kacperczyk (2009) believed that the carbon premium is
the reflection of a lower investor demand for stocks of companies
associated with high emissions.
• This paper closely follow them to explore to what extent companies
with high carbon emissions are treated like “sin stocks”by
institutional investors.
5/19
Main Research Question(s) and Hypothesis Development

1. What are the determinants of corporate carbon emissions in

firms?
Since there is little theory that can guide us on what determines the
level of carbon emissions, especially with regard to their different
sources, we include a host of firm-level variables to answer this
research question, with the following hypothesis,
H1: Firm characteristics possess a significant relationship with carbon
emissions.
2. How does carbon emissions relate to cross-sectional stock
returns?
It may expect that the forward- looking investors may seek
compensation for holding the stocks of disproportionately high
Carbon emitters. This carbon premium can be identified using
pooled OLS method by regressing total emissions on stock returns of
each firms with the following hypothesis,
H2: The carbon emissions affect stock returns significantly.

6/19
Continue..

3. Does institutional ownership reflect carbon emissions?

In the context of disinvestment hypothesis, the observed carbon
premium could be due to under-diversification resulting from
divestment and exclusionary screening of stocks with high carbon
emissions by institutional investors. To test this possibility by
looking at the portfolio holdings of institutional investors with the
following hypothesis,
H3: The carbon emissions significantly affect the portfolio holdings of
the investors.
4. Whether cross-sectional carbon premium is sensitive to
specific carbon sensitive industries?
Specific industries which are more prone to carbon emissions like oil
gas, utilities, transportation, etc. hold larger portion of carbon
emissions and therefore we observe a large carbon premium.
H4: The returns are less sensitive to differences in emissions across
firms.
7/19
Continue....

5. Whether carbon premiums in stock returns could be affected

by the change in investors awareness?
The carbon premium in stock returns could also be affected by the
changing awareness of investors about carbon risk.
Paris Agreement in 2015
By using DID method before and after the the Paris agreement to
analyze whether the investors awareness changes the carbon
premiums due to these events with the following hypothesis,
H5: Carbon premiums would change by changing the levels of
investors awareness.

8/19
Sample and Data

1. The sample period is between 2005 and 2017 with sample of 3917
companies in the US using GIC 6 industry classification.
2. Data on Corporate Carbon emission:Main variable of interest.
Firm-level carbon emissions data are assemble by seven main
providers: CDP, Trucost, MSCI, Sustainalytics, Thomson Reuters,
Bloomberg, and ISS.
Carbon emission is measured by three indicators,
a. SCOPE 1: Direct emission by the company.
b. SCOPE 2 emission generate by purchase heat, steam and electricity
consumed by the company.
c. SCOPE 3 emission due to the operations and products of the firm
but sources not owned or controlled by the company.
3. Variables in cross-sectional return regressions: Main
Dependent variable
Monthly stock returns data from FactSet, Compustat.

9/19
Econometric Identification

A. How does carbon emissions relate to cross-sectional stock returns?:

Pooled OLS with SE clustered by industry and year level
RETi,t = α0 +α1 LOG (TOTEMISSION)i,t +α2 Controlsi,t−1 +µt +εi,t
B. Does institutional ownership reflect carbon emissions?: Pooled OLS
with SE clustered by industry and year level
IOi,t = d0 + d1 (EMISSION)i,t + d2 Controlsi,t + εi,t
C. Whether carbon premiums in stock returns could be affected by the
change in investors awareness?: DID with SE clustered by
industry and year level.
RETi,t = e0 +e1 TREAT ∗AFTERi,t +e2 Controlsi,t +e3 µi +e4 µt +εi,t
where, Treatment Firms: Largest quantile with highest carbon
emission as of the end of 2014. After: indicates 0/1 for the six
months before/ after Paris Agreement,2015.
10/19
Main Results

What are the determinants of corporate carbon emissions in firms?

1. All three categories of emission levels and changes in emissions are

significantly positively related to LOGSIZE.
2. Interestingly, only diversification HHI and tangible capital LOGPPE
significantly affect carbon intensity.
11/19
Main Results

How does carbon emissions relate to cross-sectional stock returns?

Positive

12/19
Main Results

Does institutional ownership reflect carbon emissions? Yes

1. Insurance companies, Investment advisers and pension funds tend to

hold less of high scope 1 emission companies.
2. Positive but weaker ownership effects for the banks, investment
companies and hedge funds.

13/19
Main Results

Whether cross-sectional carbon premium is sensitive to specific

carbon sensitive industries? Yes-Less sensitive

14/19
Main Results

Whether carbon premiums in stock returns could be affected by

the change in investors awareness?Yes

1. Strong and Positive effect of Scope-1 emission but no significant

effect for scope 2 and 3 emissions.
2. Economically, Paris Agreement resulted in an average increase in
returns of more than10.6 percent over the six-month period.

15/19
Conclusion

How is climate change affecting stock returns? Across several

different complementary data sources and empirical strategies the study
found that,

1. Employing carbon emission as a firm characteristic, the study finds a

robust evidence that carbon emissions significantly and positively
affect stock returns.

2. The study could not explained the presence of carbon premiums

through sin stock disinvestment effect.

3. The study finds a robust evidence of significant carbon premiums for

total and growth emission but not for carbon intensity.

16/19
Methodology Issues

1. Carbon premiums could arise due to linear assumption of OLS

between stock returns and carbon emission .

2. Data inconsistency and correlation according to Busch et al. (2018)

a. Little variation in the reported scope 1 and 2 emissions data across
the data providers
b. Correlations in the reported scope 1 (scope 2) data average 0.99
(0.98) with a lot of missing data.
c. Only two data providers, Trucost and ISS ESG, provide estimates of
scope 3 emissions.

3. This study only incorporate US firms and due to sample limitation,

the carbon premiums are positively related to carbon emissions.

17/19
Possible Extension

1. Revisiting the same data with non-linear models or non-parametric

approach (Carbon Premium: Is It There? (Shaojun Zhang, 2023)

2. By incorporating other countries data will further help to identify,

a. The presence of carbon premiums in other financial markets in the
world.

b. Could find the answer, why there is no presence of carbon premiums

through sin stock disinvestment effect.

c. It will help to access the international behaviour of institutional

investors across the world regarding carbon premiums.

18/19
THANK YOU

19/19