The (carbon) price of progress on climate change

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A common view in the financial sector is that carbon prices are harmful: by reducing the profitability of companies, a higher price will lower stock prices. But, while this may be true in the long run if carbon taxes rise permanently 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 thus benefit financial markets. . A key condition is that the price of carbon must respond to economic fluctuations.

Financial markets have entered a new era that incorporates sustainability. They have become central to the global effort to tackle climate change and build a more sustainable future. As the world moves towards a low-carbon economy, carbon pricing policy is increasingly important in investment decisions. It is creating new opportunities for sustainable investing and driving the growth of green finance.

Climate policy also poses major macroeconomic challenges. Reaching net zero by 2050 requires a permanent increase in the price of carbon. To meet stringent emissions reduction targets, companies will need to pay a carbon price or reduce their emissions by investing in greener manufacturing facilities.

As pointed out in our latest research, Green Asset Pricing, carbon pricing policies will play a central role in shaping market fundamentals. Indeed, according to Jean Pisani-Ferry of the Peterson Institute for International Economics, the world’s cumulative sum of investment spending to reach net zero represents half of current GDP, while carbon tax revenues could account for 5%. Carbon policies will therefore not only affect corporate earnings and growth prospects, but also the ability of governments to finance deficits.

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Our main thesis is that, if well designed, carbon policies can play the role of automatic stabilizers by cooling the economy during booms and stimulating it during recessions. Indeed, a government that cuts the price of carbon during a recession provides relief to companies by supporting their profitability. Lowering the price of carbon during recessions not only stimulates production, but also supports investment and employment when it’s needed most. 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 linked to the uncertainty surrounding the economy. Macroeconomic volatility, being a major source of uncertainty for investors, is a key determinant of risk premia. A more volatile economy depresses risky asset valuations causing investors to demand higher risk premiums to offset this uncertainty. As a result, well-designed carbon policies can stabilize financial markets and lower risk premia if they are used to reduce macroeconomic volatility.

Reducing the carbon price burden in a recession also makes sense from an environmental perspective. Because carbon emissions are strongly correlated with the business cycle, they typically decline sharply during major economic downturns, such as the global financial crises and Covid-19. The need to reduce emissions to preserve the environment is therefore less pressing in times of greater recession.

Financial markets have entered a new era that incorporates sustainability

Rising carbon prices during booms create strong incentives for companies to adopt greener technologies. Such a policy also reduces procyclicality shifts largely tied to the broader business cycle by reducing investment in brown projects that worsen the climate crisis. Given the costs associated with the green transition, however, our findings suggest that this transformation should mostly occur during booms, when the economy is strong.

These gains are also not limited to the financial markets. A reduction in the price of carbon during recessions translates into lower energy costs for consumers, which can support spending and provide an additional boost to the economy. Such a policy would also help alleviate political opposition and social unrest related to rising energy prices, such as those seen during the French yellow vest protests.

But how to put this policy into practice? Business-related systems, such as the cap and trade systems implemented in Europe and California, could in principle reconcile economic, financial and environmental goals. While still imperfect, the EU’s emissions trading system has provided the positive correlation between the carbon price and economic activity needed to reap these gains in recent years.

In summary, if linked 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 reduces investors’ premiums required to hold risky assets, but also stabilizes financial markets. Furthermore, the examples from 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 Universit Paris Dauphine, are authors of Prices of green resources (ECB Staff Working Paper, 2020).

The views expressed in the document and in this article are those of the authors and do not necessarily reflect those of the ECB.