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© 2022 International Monetary Fund
WP/22/231
IMF Working Paper
Institute for Capacity Development
The Carrot and the Stock: In Search of Stock-Market Incentives for Decarbonization
Prepared by Laurent Millischer, Tatiana Evdokimova, Oscar Fernandez*
Authorized for distribution by Mercedes Garcia-Escribano
November 2022
IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.
ABSTRACT: Financial markets can support the transition to a low-carbon economy by redirecting funds from highly emissive to clean investments. We study whether European stock markets incorporate carbon prices in company valuations and to what degree they discriminate between firms with different carbon intensities. Using a novel dataset of stock prices and carbon intensities of 338 European publicly traded companies between 2013 and 2021, we find a strongly statistically significant relationship between weekly carbon price changes and stock returns. Crucially, this relationship depends on firms’ carbon intensity: the higher the carbon costs a firm faces, the poorer its stock performance during the periods of carbon price increases. Emissions covered with free allowances however do not affect this relationship, illustrating how both carbon pricing and disclosures are needed for financial markets to foster climate change mitigation. The relationship we identify can provide an incentive for firms to decarbonize. We argue in favor of more ambitious carbon pricing policies, as this would strengthen the stock-market incentive channel while causing only limited financial stability risk for stocks.
RECOMMENDED CITATION: Millischer, L., Evdokimova, T., and Fernandez, O. (2022). The Carrot and the Stock: In Search of Stock-Market Incentives for Decarbonization. IMF Working Paper WP/22/231.
| JEL Classification Numbers: | G12; G14; Q53; Q54; Q54 |
| Keywords: | European Union Emissions Trading Scheme; Carbon price; Stock price valuation; Climate Finance; Climate Change Mitigation; Multifactor Market Model |
| Author’s E-Mail Address: | lmillischer@jvi.org (0000–0001 -6704–1358), tevdokimova@jvi.org, oscar.fernandez@wu.ac.at |
| JEL Classification Numbers: | G12; G14; Q53; Q54; Q54 |
| Keywords: | European Union Emissions Trading Scheme; Carbon price; Stock price valuation; Climate Finance; Climate Change Mitigation; Multifactor Market Model |
| Author’s E-Mail Address: | lmillischer@jvi.org (0000–0001 -6704–1358), tevdokimova@jvi.org, oscar.fernandez@wu.ac.at |
Title Page
WORKING PAPERS
The Carrot and the Stock: In Search of Stock-Market Incentives for Decarbonization
Prepared by Laurent Millischer, Tatiana Evdokimova, Oscar Fernandez
Contents
1. Introduction
2. Literature Review
Multifactor market model approach
Capital Asset Pricing Model approach
Identifying clean firms
Alternative Analysis Techniques
Contribution of this paper
3. Data
3.1 Dataset
3.2 Stylized Facts
4. Econometric Analysis
4.1 Theory
4.2 Specification for empirical analysis
4.3 Full sample estimates
Total carbon intensity
Free and paid carbon intensity
4.4 Sub-sample estimates
Results by industry
Results by sub-periods
Results by country groups
4.5 Permanence of the effect
4.6 Event study using regulatory updates
Data with daily frequency
Regulatory update events
5. Discussion
5.1 Conclusions
The carrot and the stock
5.2 Policy implications
Strengthening the decarbonization incentive
Mitigation: transparency vs. carbon pricing
Financial stability
References
Appendix
A.1 Orbis and EU ETS data matching
A.2 Theory derivation
A.3 Industry-subperiod estimates
A.4 Robustness checks
A.4.1 Controls selection
A.4.2 Clustering of standard errors
A.3.2 Timing of purchases
A.3.3 Normalization variables
A.3.4 Allowance inventories
A.3.5 R&D expenditure
The authors thank Jesus Crespo (WU), Alessio Saretto (Federal Reserve Bank of Dallas), Divya Kirti (IMF), Malcolm Wardlaw (University of Georgia), Andre B.M. Souza (BSE), Joxe Mari Barrutiabengoa Ortubai (BBVA Research) and Mar Reguant (Northwestern University) for many helpful comments. The authors are also thankful for comments and suggestions received from participants during research seminars at Joint Vienna Institute (JVI), the Austrian National Bank (OeNB), the IMF Institute for Capacity Development (ICD) and the European Central Bank (ECB).