16 March 2020

Climate Policy, Stranded Assets, and Investors’ Expectations

Transitioning to a climate-friendly economy inevitably entails decommissioning fossil-fuel assets. The share prices of these investments will depreciate. The authors show that investors expect compensation for this. Policymakers should provide clear signals about their plans for decarbonization and financial compensation. This is important because shocks to investors’ expectations about the stringency and consequences of climate policies constitute a risk for financial markets.

Key issue

With tightening climate policies, some assets in the energy sector, such as coal reserves or coal-fired power plants, are at risk of becoming stranded. If financial markets do not price in this risk, this can lead to costly consequences for the whole economy: valuations of many companies with significant market capitalization might be adjusted too late and too suddenly. Financial institutions such as the Bank of England or the European Systemic Risk Board (ESRB) have identified the mispricing of stranded asset risk as a potential systemic risk and threat to financial stability. We study whether the current market valuation of companies owning fossil fuel assets reflects this risk of stranding assets.

Approach and methodology

We follow the gradual development of a climate policy proposal in Germany targeting lignite (brown coal) assets. The initial “climate levy” proposal was directed at stranding lignite assets by charging an extra fee on carbon emissions (Stage 1). After protests from stakeholders, the proposal transformed into a compensation mechanism, paying power plant owners for not running their units (Stage 2). Being concerned with these state payments to firms, the European Commission announced the opening of a state aid procedure, thus challenging the compensation plans (Stage 3). Using stock market data, we investigate how adjustments of the proposal have affected the market valuation of firms active in electricity production. This allows us to draw conclusions on investors’ prior and updated beliefs.

Key findings and conclusions

Our results suggest that financial market investors expect compensation for stranded coal assets. We show that stock markets did not react to the announcement of the climate levy proposal, or to that of the compensation mechanism. Only announcements that the compensation mechanism may not go through due to a violation of state aid rules prompted a significant and negative reaction: this was the news item that ran contrary to investors’ prior expectations. The results highlight the importance of interlinkage between climate policy and financial markets. Policymakers should commit to a clear path of decarbonization and/or fixed compensation payments in order to avoid more costly compensation or disruptions in financial markets.