Companies that fail to curb their carbon output may eventually face the consequences of asset devaluation and stock price depreciation, according to a new study out of the University of Waterloo.

The researchers further determined that the failure of companies within the emission-intensive sector to take carbon reduction actions could start negatively impacting the general stock market in as little as 10 years' time.

"Over the long-term, companies from the carbon-intensive sectors that fail to take proper recognizable emission abatements may be expected to experience fundamental devaluations in their stocks when the climate change risk gets priced correctly by the market," said lead author Mingyu Fang, a PhD candidate in Waterloo's Department of Statistics and Actuarial Science.

"More specifically for the traditional energy sector, such devaluation will likely start from their oil reserves being stranded by stricter environmental regulations as part of a sustainable, global effort to mitigate the effects caused by climate change.

"Those companies may find that large portions of the reserves are at risk of being unexploitable for potential economic gains."

Climate change impacts investment portfolios through two channels. Directly it elevates weather related physical risk to real properties and infrastructure assets, which extends to increased market risk in equity holdings with material business exposures in climate sensitive regions. Indirectly it triggers stricter environmental regulations and higher emission cost in a global effort in emission control, which shall induce downturns in carbon intensive industries in which a portfolio may have material positions.

This indirect impact of climate change on investments will effectively be transformed into a political risk affecting particular asset classes, often referred to as the investment carbon risk.

As part of the study, which grew out of Fang's PhD thesis as well as a funded research project by the Society of Actuaries under the theme of 'Managing Climate and Carbon Risk in Investment Portfolios', the researchers undertook an inter temporal analysis of stock returns. They examined 36 publicly traded large emitters and related sector indices from Europe and North America around the ratification of major climate protocols.

Only nine of the 36 samples were found to display recognizable carbon pricing. The historical performance of the emission heavy sectors, such as energy, utilities, and material was also compared against those of the other industries. The carbon-intensive sectors consistently ranked at the bottom of the list across the metrics used and underperformed the market indices for both Europe and North America.

"It is in the best interest of companies in the financial, insurance, and pension industries to price this carbon risk correctly in their asset allocations," said Tony Wirjanto, a professor jointly appointed in Waterloo's School of Accounting and Finance and Department of Statistics and Actuarial Science, and Fang's PhD thesis supervisor.

"Companies have to take climate change into consideration to build an optimal and sustainable portfolio in the long run under the climate change risk."

Research Report: "Sustainable portfolio management under climate change"

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University of Waterloo
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