A common view in the financial industry is that carbon prices are detrimental: by reducing the profitability of companies, a higher price will lower share prices. But, while this may be true in the long run if carbon taxes permanently rise at a constant rate, it can be argued that, in the short to medium term, a price on carbon emissions can reduce macroeconomic risk — and hence benefit financial markets. One key condition is that carbon pricing needs to respond to economic fluctuations.
Financial markets have entered a new era that incorporates sustainability. They have become central to the global effort to address climate change and build a more sustainable future. As the world shifts to a low-carbon economy, carbon pricing policy is increasingly important in investment decisions. It is creating new opportunities for sustainable investments and driving the growth of green finance.
Climate policy also raises important macroeconomic challenges. Reaching net zero by 2050 requires a permanent increase in the price of carbon. To comply with stringent emission reduction targets, companies will either have to pay a carbon price or reduce their emissions by investing in greener production facilities.
As underlined in our latest research, Green Asset Pricing, carbon price policies will play a central role in shaping market fundamentals. Indeed, the world cumulative sum of investment spending to reach net zero represents half of current GDP, while carbon tax revenues could represent 5 per cent, according to Jean Pisani-Ferry of the Peterson Institute for International Economics. Carbon policies will therefore not only affect the earnings and growth prospects of companies but also governments’ ability to finance deficits.
Our main contention is that, if well-designed, carbon policies can play the role of automatic stabilisers by cooling down the economy during booms and stimulating it during recessions. Indeed, a government that reduces the price of carbon during a recession provides relief to companies by supporting their profitability. Lowering the price of carbon in downturns not only stimulates production but also supports investment as well as employment precisely when it is most needed. Over the cycle, this policy reduces macroeconomic volatility, as it weakens economic activity and profits during booms.
How would a time-varying carbon price affect financial markets? Risk premiums, which in turn affect stock prices, are related to the uncertainty surrounding the economy. Macroeconomic volatility, being a main source of uncertainty for investors, it is a key determinant of risk premiums. A more volatile economy depresses valuations of risky assets by inducing investors to demand higher risk premiums to compensate for this uncertainty. Consequently, well-designed carbon policies can stabilise financial markets and lower risk premiums if they are used to reduce macroeconomic volatility.
Reducing the burden of carbon pricing in a recession also makes sense from an environmental perspective. Since carbon emissions are very strongly correlated with the business cycle, they typically decline abruptly during major economic downturns, such as the global financial and Covid-19 crises. The need to curb emissions to preserve the environment is therefore less pressing during periods of major recessions.
Increasing the price of carbon during booms creates strong incentives for companies to adopt greener technologies. Such a policy also lowers procyclicality — variations broadly linked with the wider economic cycle — by reducing investments in “brown” projects that worsen the climate crisis. Given the costs associated with the green transition, however, our results suggest that this transformation should mainly happen during booms, when the economy is strong.
These gains are also not limited to financial markets. A reduction in the price of carbon during recessions results in lower energy costs for consumers, which can support spending and provide a further boost to the economy. Such a policy would also help ease political opposition and social unrest linked to higher energy prices, such as those witnessed during the French “yellow vest” protests.
But how to implement this policy in practice? Schemes that are connected to economic activity, such as the cap and trade systems implemented in Europe and California, could in principle reconcile economic, financial and environmental objectives. While still imperfect, the EU’s Emissions Trading System in recent years delivered the positive correlation between the price of carbon and economic activity that is needed to achieve these gains.
In summary, if connected to economic activity, a price on carbon emissions can have beneficial effects on financial markets by reducing economic procyclicality. A reduction in macroeconomic volatility not only lowers the premiums demanded by investors for holding risky assets but also stabilises financial markets. Moreover, the examples of Europe and California suggest that time-varying carbon policies can be successfully implemented in practice.
Ghassane Benmir of the London School of Economics and Political Science, Ivan Jaccard of the European Central Bank, and Gauthier Vermandel of CMAP, Ecole Polytechnique, Paris, and PSL Research — Université Paris Dauphine, are authors of Green Asset Pricing (ECB working paper, 2020).
The views expressed in the paper and this article are those of the authors and do not necessarily reflect those of the ECB.
Source: Economy - ft.com
