Are Financial Markets Pricing the Net Zero Carbon Transition?

Prior research has highlighted a positive correlation between realised returns and carbon emissions. The paper presented in this ZEW Decarbonization Seminar/Joint Seminar ZEW and MISES shows that the high realised returns of high-carbon firms might be partially due to mispricing produced by climate policy uncertainty. For this reason, realised returns may not be a good proxy of expected returns. To show that, the author develops an asset pricing model with uncertain expectations about the future cash flows of fossil fuel firms. The price-dividend ratio increases with uncertainty about a climate policy regime shift. This proposition is confirmed empirically using data on analysts’ forecasts. He finds that the positive factor loading of analysts’ forecast disagreement on the valuation of fossil fuel stocks increases for more carbon-intensive firms. Using his model, he shows with forward-looking scenarios that the valuations of fossil fuel firms may not be consistent with high expected returns as investors may reprice their cash flow expectations.