Zacharias Sautner
Professor of Finance, Head of Finance Department
Zacharias Sautner is Professor of Finance and Head of the Finance Department at Frankfurt School of ...

Carbon Tail Risk

July 20, 2018
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Climate change imposes large risks on firms. It is widely understood that policymakers need to substantially increase regulation to meet international agreements to combat a global temperature rise. New regulations related to climate change, but also technological innovations, can have sudden and drastic effects on firms’ stock prices. When the German government decided to exit nuclear power to move into greener alternatives following the Fukushima disaster, stock prices of major utilities such as RWE and E.ON dropped by more than 40% within a few months. Regulatory and technological climate risks are particularly pronounced for firms with large carbon emissions, and they are therefore frequently referred to as “carbon risks”.

In a new paper, me and my FS-coauthors Emirhan Ilhan and Grigory Vilkov, estimate the effects of carbon emissions on corporate risk profile. We focus on left-tail or downside risk to capture the market’s perception of jump risks, reflecting big drops in stock prices as in the German utilities example. Investors have been known to include left-tail risks in analyzing the risk characteristics of companies. We estimate left-tail risk as the tail loss reflected in out-of-the-money put options. This measure quantifies the market’s perception of jump risks that may materialize before an option matures. The measure is equivalent to the conditional variance-at-risk, though it is computed under the risk-neutral measure. An advantage of the measure is that it is forward-looking.

We start by characterizing the carbon footprint of companies in our S&P500 sample, using survey data from CDP about firms’ carbon footprints. Carbon emissions are highly concentrated among a small set of industries and firms. Notably, six industries make up more than 80% of all carbon emissions across our sample. The single most important emission contributor is the electric, gas, and sanitary services sector, making up 47% of all sample emissions. Exxon Mobil is the largest single contributor of carbon emissions in our sample, responsible for 140 million metric tons of CO2 per year.  Several firms in the electric, gas, and sanitary services, such as American Electric Power Company, follow the energy giant.

We then provide strong evidence that carbon emissions are positively and significantly associated with corporate tail risks, elicited from options with two-year maturities. We use two-year maturities as shorter-term options are more sensitive to jumps, while longer maturity options react better to general asymmetric volatility effects. The relationship between carbon emissions and tail risk is larger for firms in industries that release more carbon. Our results indicate that investors view firms with high carbon emissions as having a big downside in the case of sudden climate-related regulations or innovations.

Investors and the scientific community agree that climate risks exist and are substantial, but a major challenge is that the time horizons over which these risks likely materialize is highly uncertain. Constituting a first step towards better understanding the timing structure of carbon tail risks, we explore also options with maturities of one month and one year. We find a positive effect of carbon emissions across both maturities, though the effect is statistically significant only for one-year options

We close by exploring the effects of emissions on two economically related outcome variables: CDS spreads and dispersions in beliefs. The former variable captures the market’s perception of a firm’s general business risk, while the latter is a measure of the market uncertainty around corporate earnings over a short-time horizon (obtained from analyst forecasts). Carbon emissions and CDS spreads are positively, but not statistically significantly, related. They are hence most relevant as an indicator of left-tail events, rather than general business risk. However, we find a significant and positive relationship between dispersion in beliefs and carbon emissions. This suggests that high carbon emissions increase earnings uncertainty.

A key implication of our paper is that carbon tail risks are relevant today and that market participants already incorporate them into option prices. Markets expect significant downward jumps in asset prices because of climate change. Our findings confirm concerns by regulators such as Mark Carney, who stated that financial stability may be adversely affected by climate change. Institutional investors and regulators should therefore take measures to be prepared for large negative climate events.

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