In search of carbon alpha

We are used to thinking about how movements in oil or natural gas prices can affect the fortunes of our biggest companies. Very few investors and analysts contemplate the impact that a significant change in carbon prices could have on the share price of individual firms.

But as carbon prices rise and compliance costs become a more significant burden, the likelihood that the compliance carbon market will have a material impact on corporate valuations is expected to increase. In this article I delve into some of the latest research into the impact that carbon markets are having on UK and European equity markets and macroeconomic variables, uncovering where investors might be missing out on carbon alpha.

Most studies analyse the relationship between carbon prices and the share price returns from carbon intensive versus non-carbon intensive firms, or base their analysis on a relatively small time period, perhaps focusing on an important unexpected market event, and often missing out on the most recent period of high carbon prices.

For example, in Does the stock market care about the carbon price? I highlight research published by the International Monetary Fund (IMF). They analysed stock returns (covering 338 European-listed companies) relative to the percentage of their revenue spent on EU emission allowances (EUAs). The IMF’s analysis shows that since 2018, a 1% carbon price increase since 2018 is associated with a stock price drop of up to 0.21% for the most polluting companies. It’s a useful study, but we really need much deeper insights to be useful for investors.