The Financial Cost of Carbon
What does climate finance stand for? In The Financial Cost of Carbon, Patrick Bolton, Professor of Finance at Columbia Business School, Zachery Halem, Director of the Lazard Climate Center, and Marcin Kacperczyk, Professor of Finance at Imperial College, argue that climate finance is a risk management problem – a problem which means three things for investors.
First, prudent investors will seek to hedge climate change risk by reducing their exposure to the risk. Second, investors will demand compensation for holding this risk. Third, investors will engage with companies to induce them to reduce this risk if they are not adequately compensated for it. For companies, the main implication of climate risk management by investors is that the firms with greater carbon emissions will have to pay a higher financial cost of carbon.
In this paper, the Lazard Climate Center undertakes a comprehensive analysis of the risk compensation implications of exposing investors to carbon transition risk, and explores how corporate GHG emissions have affected the price-to-earnings ratios of listed companies in Europe and the U.S. over the period 2016 to 2020.
The paper finds that financial markets are beginning to broadly discount companies which stand out for their high carbon emissions and that price-earnings ratios are lower for companies with higher emissions, with this discount varying significantly by sector and across firm size, with larger companies experiencing larger discounts.
Overall, what emerges is a clear pattern of investors’ growing concern over climate risk, which translates into an increasingly material financial cost of carbon for companies with high GHG emissions.