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In the financial industry, there is a common perception that higher carbon prices are harmful as they can reduce company profitability and lower share prices. However, it can be argued that in the short to medium term, carbon pricing can actually reduce macroeconomic risk and benefit financial markets, as long as it responds to economic fluctuations.
Financial markets are now embracing sustainability as they play a central role in addressing climate change and working towards a more sustainable future. Carbon pricing policies are increasingly important in investment decisions and are driving the growth of green finance.
Implementing climate policy poses macroeconomic challenges. Achieving net zero emissions by 2050 requires a permanent increase in carbon prices. Companies will need to either pay a carbon price or invest in greener production facilities to meet emission reduction targets.
According to our latest research paper, Green Asset Pricing, carbon price policies will have a significant impact on market fundamentals. The cumulative global investment spending required to reach net zero is estimated to be half of the current GDP, and carbon tax revenues could represent 5% of GDP, as stated by Jean Pisani-Ferry of the Peterson Institute for International Economics. Carbon policies will thus affect not only company earnings and growth prospects but also governments’ ability to finance deficits.
FT Business School Insights: Sustainability
Read the report here and explore research by leading professors, features, and academic and business opinion on sustainability.
We argue that well-designed carbon policies can act as automatic stabilizers for the economy, cooling it during booms and stimulating it during recessions. When a government reduces the carbon price during a recession, it provides relief to companies by supporting their profitability. Lowering the carbon price not only stimulates production but also boosts investment and employment when they are most needed. This policy reduces macroeconomic volatility over the cycle by weakening economic activity and profits during booms.
How would a time-varying carbon price impact financial markets? Risk premiums, which influence stock prices, are tied to economic uncertainty. Macroeconomic volatility, a major source of uncertainty for investors, affects risk premiums. A more volatile economy lowers valuations of risky assets as investors demand higher risk premiums to compensate for the uncertainty. Therefore, well-designed carbon policies can stabilize financial markets and decrease risk premiums by reducing macroeconomic volatility.
Reducing the burden of carbon pricing in a recession also makes environmental sense. Carbon emissions are strongly correlated with the business cycle, declining during major economic downturns. Hence, the urgency to curb emissions for environmental preservation is less during recessions.
Increasing the carbon price during booms incentivizes companies to adopt greener technologies. This policy also reduces procyclicality by discouraging investments in “brown” projects that worsen the climate crisis. However, given the costs associated with the green transition, our results suggest that this transformation should predominantly occur during booms when the economy is strong.
These benefits extend beyond financial markets. Lowering the carbon price during recessions reduces energy costs for consumers, supporting spending and providing an additional boost to the economy. This policy can also help alleviate political opposition and social unrest associated with higher energy prices, as seen during the French “yellow vest” protests.
Implementing this policy in practice can involve schemes connected to economic activity, such as cap and trade systems like the EU’s Emissions Trading System. Although still imperfect,
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