Are stock markets discounting a carbon bubble?

Last week The Guardian reported:

Stock markets are inflating a “carbon bubble” by overvaluing companies that produce fossil fuels and greenhouse gases, and this poses a serious threat to the economy, an influential committee of UK MPs has warned.

The argument being that fossil fuel companies have more oil and coal reserves than can ever be exploited without triggering a climate catastrophe. This also forms the basis for a divestment campaign – in essence the divestment campaign isn’t just some grubby secondary boycott but rather a sensible movement away from overvalued assets.

This type of argument assumes that stock markets are informationally inefficient. Furthermore that investors could earn super-normal returns by following a mechanical trading rule. Not just any old rule, but a well-known well publicised rule – just don’t buy fossil fuel stocks. But that doesn’t sound right – earning a super-normal profit off information and a trading rule that everyone knows? That’s not going to happen – not unless everyone else is irrational. We should always be suspicious of any theory that relies on everyone else being irrational.

A working paper, recently published on the Social Science Research Network, investigates this notion that somehow the stock market is ignoring a carbon bubble – or discounting climate science. A layperson explanation here.

The study examined the stocks of the 63 largest U.S. oil and gas companies that trade on the major U.S. exchanges. Most of them disclosed significant oil and gas reserves in their financial statements. As a result, there was a higher likelihood that these companies’ stock prices might be affected by investors’ perceptions about the consequences of unburnable carbon.

The researchers studied 88 stories from 59 print media outlets, most in 2012 and 2013, and an initial story in 2009 published in the scientific journal Nature. Each story was considered a separate event that could potentially affect stock prices, with researchers measuring the average effect.

U.S. oil and gas stock prices dropped about 2 percent after the original 2009 Nature story (a total value of $27 billion). The ensuing widespread coverage had little impact on the U.S. oil and gas companies’ stock prices, which dipped by a half percent collectively.

So how do they interpret that result?

This small but detectable market response coincident with unburnable carbon news stands in contrast with the prediction of some analysts and commentators of a substantial decline in the shareholder value of fossil fuel firms from stranded carbon (e.g., HSBC 2013). We also find it interesting that one of the most cited environmental science studies in recent years seems to have had only limited sway with energy company investors, at least those who invest in U.S. oil and gas stocks, and regulators tasked with improving company disclosures about the risks of climate change for balance sheet valuations (e.g., SEC 2010).

So it isn’t that the stock market is ignoring the science or news of a carbon bubble – but rather that the market does not value the news as much as environmentalists would like.

The authors speculate why that may be the case:

  1. Markets may anticipate that carbon capture and sequestration technology may become viable.
  2. Markets may anticipate that government’s will compensate existing firms for their carbon reserves.
  3. Markets may anticipate that the oil and gas industry will avoid the carbon bubble but, say, coal won’t.
  4. The risks of the bubble are not being reported in financial statements and so are not fully priced.

Then finally there is this:

A final possible explanation for the limited stock price impact relates to the effects of potential media bias, which prior work suggests should be small, as energy stocks are largely held by institutional investors, trade in efficient markets, and their prices reflect a wide range of investment strategies with relatively few constraints. Our results are consistent with this view, as they show a small but detectable delayed reaction.

It could be that the media (and environmental activists) are over-hyping the actual risks that are fully priced in the market.

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12 Responses to Are stock markets discounting a carbon bubble?

  1. Sinclair, a great post.

    the estimated 2% reduction in share prices is not much at all! a small bump rather than a bubble.

  2. blogstrop

    We should always be suspicious of any theory that relies on everyone else being irrational.

    That’s the foundation much of our media appears to be working from. If they say divest fossil fuels often enough, it becomes accepted dogma. How else did the CO2 scam become a force in politics for so long?

  3. johanna

    It’s all part of the divestiture campaign. Al Gore has been spouting the same nonsense, for the same reason.

    I loved this bit of babble:

    The researchers studied 88 stories from 59 print media outlets, most in 2012 and 2013, and an initial story in 2009 published in the scientific journal Nature. Each story was considered a separate event that could potentially affect stock prices, with researchers measuring the average effect.

    This is meant to be rigorous research on stock prices? What a joke. I’d love to know how they “measured” the effect of the articles – by reading tealeaves or counting cracks in the pavement maybe?

  4. Sinclair Davidson

    Johanna – I linked to the paper – read it.

  5. can a divestiture campaign against carbon work in an efficient share market?

    there is lots of money to be had buying from people who sell for non-rational reasons. why people sell at the wrong time does not matter that much to those that accept their bargain price?

  6. johanna

    I did, Sinc.

    My point is that the link they posit between the appearance of selected articles and stock prices is utterly tenuous. It cannot be “measured”, because cause and effect cannot be proved. The premise is flawed – so their results based on this “metric” are worthless.

  7. Joanna, share market event studies can sniff out the most closely held information.

    See The Stock Market Speaks: How Dr. Alchian Learned to Build the Bomb by Joseph Michael Newhard, August 27, 2013 at http://www.terry.uga.edu/events/details/2444 for a replication study of Armen Alchian’s event study of capital market reactions to nuclear detonations in 1954 updated with declassified information and modern finance theory.

    Alchian successfully identifying lithium as the fissile fuel using only publicly available financial data. The early 1950s RAND memo by Alchian was classified soon after he circulated it and was destroyed.

    Not only was the components of the bomb classified, whether the explosion was atomic or hydrogen was classified too, but the share price of the supplier of lithium surged within a few days.

  8. Sinclair, that was a classic. Identified the supplier of the faulty component the same morning as the crash down the the last dollar they would lose in profits and business. pretty good master’s thesis!

  9. johanna

    There is a big difference between stock market reaction to a concrete event that damages a brand (like a food contamination episode, or your component causing a space shuttle to explode) and to speculative comment about a large class of commodities like fossil fuels.

    The difference lies in the capacity to attribute any price changes. If your baby food starts poisoning babies, and it is widely reported, then the inevitable fall in your share price can reasonably be attributed to the event. But, the regular spates of “coffee is going to kill you, science proves” stories in the media do not seem to noticeably affect coffee prices.

    That is why I singled out this aspect of the methodology as junk – noting that the results do not in fact support the divestiture dreamers. The fact that I agree with the result doesn’t mean I should endorse the methodology.

  10. Bruce of Newcastle

    My quick look at two coal stocks – New Hope and Wesfarmers – showed they paid over 6% total dividend grossed up last year, based on the share price today.

    I’d say that their shares are pretty well valued for the yield, and even undervalued, since BHP and Rio both yield less than this.

    The market is saying to the pundits ‘we’ll believe it when we see it, meanwhile thanks for the nice cheques evil coal guys’.

    I turned on the TV in the afternoon and caught a bit of (US) PBS Newshour on SBS. They were quite excited about the Great Lakes being frozen over to a greater extent than any year since 1979. They somehow forgot to mention global warming at all in the story despite usually doing the woe all is lost thing at the smallest excuse. I’d say that the warmies who think coal miners are going to faceplant will be waiting for quite a while.

  11. Big Jim

    Finish the argument. The risks are fully priced in… And? And the global economy essentially shat itself.
    No-one wants to contemplate the real cause of the GFC. Asset price bubble… Duh, circular argument, try harder. Liquidity crisis… Yes, but why? Debt and deficit… Yes, but so what – asset prices are climbing. Sub-prime mortgages… Yes, but, why? Why is the McMansion no longer worth 500k like it was in 2006? ALL the smart guys except that Das guy and a few professional Chicken Littles knew it really, really was worth 500k and climbing. But now it isn’t. What happened.? Mid 2007 was fairly uneventful, as I recall. Please spare us question-begging non-explanations. Save yourself time by asking yourself: ‘yes but why?’ Ask it again and again until you disappear down the rabbit hole.
    The rabbit hole is crowd psychology, specifically regarding climate change. Nothing changed in the real world in one month in 2007. Crowd psychology. It’s as ethereal as fashion. One day in 2002 everyone goes to sleep thinking sideburns are grotesque old pervo yuckoes; the next morning they wake up wanting to shag Duane Allman. One day in 2007, the relentless, daily, multi-media propaganda got, as they say, ‘traction’. Then panic – the fear version of fashion – set in for the ride. In a few short months every asset on Earth was literally worth less.

    This thing will pass. Hell, for all I know, sideburns are pervo again, and pervo is a bad thing. I’m guessing? The bad news is, there are plenty of other things to panic about.

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