IIT Guwahati & IIM Bangalore Researchers make breakthrough in pricing ‘Carbon Risk,’ find long-term risks for stocks of polluting firms

The Analysis found a ‘carbon risk premium’ in stock returns, which means in short term, higher carbon emissions inflated stock price but could lead to severe losses in long-term as governments impose regulations on Greenhouse Gases (GHG) emissions

GUWAHATI : A new mathematical analysis conducted by researchers from Indian Institute of Technology Guwahati (IITG) and IIM Bangalore has established a relationship between the carbon footprint of companies and the potential risks of investing in these firms.

As the world looks to move towards a sustainable future and economies everywhere try to reduce their carbon footprint, the future of companies that rely on excessive emissions of Greenhouse Gases (GHG) remains uncertain.

An extensive data analysis of over 200 of the largest listed companies in the American market was carried out by the researchers from these top Institutions. To assess the carbon footprint of the companies, direct GHG emissions of the companies and purchased GHG emissions (in power consumption or heat) were considered.

The Research Team included Prof. Siddhartha Pratim Chakrabarty, Department of Mathematics and the Mehta Family School of Data Science and Artificial Intelligence, IIT Guwahati along with Prof. Sankarshan Basu from the Department of Finance and Accounting, IIM Bangalore and Mr. Suryadeepto Nag, a BS-MS student from IISER Pune.

The findings of this analysis were published in arXiv, a curated research-sharing platform maintained by a team at Cornell University, U.S. The link to the paper can be found at: https://arxiv.org/abs/2107.06518

The researchers found that most of these companies (71.6%) had shown a decrease in their carbon emissions in the 2016-2019 period. It was found that carbon footprint had a positive correlation with the size of the companies and the revenues. However, the correlation with expenses was found to be slightly less than that with revenue, which they attribute to the higher expenses of switching to renewable energy sources.

Highlighting the important findings of this research, Prof. Siddhartha Pratim Chakrabarty, Department of Mathematics and Mehta Family School of Data Science and Artificial Intelligence, IIT Guwahati, said, “On analyzing the data of annual stock returns, along with data of GHG emissions and other financial data (revenue, debt, and book value, among others), it was found that there exists a ‘carbon risk premium’ in the stock returns, which means in the short term, higher carbon emissions are found to be inflating the price of the stocks. It was found that a higher carbon footprint gave higher returns to investors in the short term.”

Further, Prof. Siddhartha Pratim Chakrabarty added, “The past couple of years has seen a lot of research in climate finance, and the existence of a carbon risk premium has been confirmed independently by many researchers worldwide. The existence of such a premium has been attributed to ‘carbon transition risk.’ As the adverse effects of climate change become more and more visible, governments around the world may soon impose regulations on GHG emissions or levy higher taxes and charges on companies that contribute significantly to global warming.”

If this happens, companies will begin losing profits, and in the case of extreme regulations, may even go into debt or bankruptcy, and the value of their shares may plummet. This could result in severe losses for investors, and the ensuing sell-offs could lead to other losses in the broader market.

While the estimation of the risk premium has been carried out multiple times in the last few years, there has not been much progress in quantifying future risks, until now.

In their paper, the collaboration finds a mathematical relationship between the carbon risk premium and the value of the future risk. The researchers studied the risk for different scenarios for when the regulations or “carbon transition” may happen and find a formula for the maximum exposure of each firm to the transition for different times in the future.

For one family of arrival processes (models for when the transition will happen), they find that the price of the average stock in their data could fall (at most) by 20.65% at the transition, if the transition is expected to happen in 10 years’ time from now, and 41.3% if the transition is expected to happen 20 years from now. The corresponding figures for most of polluting firms are 45.04% and 90.08% respectively.

The researchers also demonstrate the different scenarios in which investors could profit from the premium-risk tradeoff as well and show the cases in which it is more profitable to hold on to a stock for the premiums and those where it is more profitable to sell or short the shares.