Blind to Carbon Risk? An Analysis of Stock Market’s Reaction to the Paris Agreement
18 Pages Posted: 27 Dec 2018 Last revised: 15 May 2019
Date Written: December 9, 2018
There is growing awareness of the fact that a transition to sustainable finance is crucial to scale-up low-carbon investments needed to achieve the climate targets. Nevertheless, most investors’ portfolios are still highly exposed to financial assets issued by “brown” firms, i.e., firms that rely directly or indirectly on fossil fuels energy. Main barriers to portfolio’s reallocation towards low-carbon activities are the lack of a standardized “green taxonomy” and the lack of conclusive evidence on whether it pays to go green. In particular, it is unclear whether the market is reacting to climate announcements by rewarding (penalizing) low-carbon (carbon-intensive) assets. We contribute to fill in this gap by developing an empirical analysis of the low-carbon and carbon-intensive indices for the EU, US and global stock markets, using robust methods to analyze their performance in terms of systematic risk (beta) and portfolio optimization, before and after the Paris Agreement (PA). We test whether the financial market is pricing the PA by decreasing (increasing) the systematic risk and increasing (decreasing) the portfolio weights of low-carbon (carbon-intensive) indices afterwards. We find that the overall systematic risk for the low-carbon indices decreased after the PA, while it increased for most of the carbon-intensive indices considered. Moreover, the weight of the low-carbon indices within an optimal portfolio tends to increase as well after the PA. This evidence suggests that market participants perceive carbon-intensive assets as riskier and hence demand higher risk premia than before the PA, while low-carbon assets start to be considered more appealing for investment opportunities.
Keywords: asset pricing, Paris Agreement, low-carbon indices, high-carbon indices, systematic risk, portfolio optimization, risk-adjusted return, carbon stranded assets
JEL Classification: C22, C58, Q54
Suggested Citation: Suggested Citation