June 17, 2021

Why Researchers Say Carbon-Intensive Stocks Are Overpriced

Why Researchers Say Carbon-Intensive Stocks Are Overpriced

According to research out of the University of Waterloo, the market overvalues most carbon-intensive companies, such as oil and coal producers. Climate change will severely limit the potential of carbon-intensive industries in the future. The effects on businesses may be direct, such as property damaged by extreme weather, as well as indirect, perhaps through government intervention and regulation.

That might be bad news for investors with carbon-heavy portfolios. On the other hand, fears about future regulation could push people toward newer low-carbon technologies faster than anticipated. The market eventually might help fight climate change, and that would present an opportunity for smart investors looking to invest in the growth of carbon-neutral companies.

The Dual Dangers of Climate Change for Stocks

In a study published in the Journal of Sustainable Finance & Investment, researchers from the University of Waterloo found that companies in carbon-intensive sectors are at significant risk from the effects of climate change.

The direct effects on physical assets have been common knowledge for some time. However, study author Mingyu Fang stated in a release to Eureka Alert that, "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."

The two main effects of climate on stock prices are:

1. Direct impacts on physical assets

As oceans rise and weather becomes more extreme, the risk of property damage increases significantly, especially along the coasts. As climate change worsens, any company with extensive holdings in coastal areas is at risk of property losses.

For example, oil companies relying on refineries and rigs in the Gulf of Mexico will face more powerful hurricanes, longer hurricane seasons and higher storm surges.

2. Indirect effects through increased regulation

As climate change continues to cause problems, such as flooding, drought and extreme storms, people will finally demand tighter controls on carbon emissions. These might include set limits or more flexible carbon-pricing measures.

Canada and Europe are already well into preliminary efforts to make significant cuts to carbon emissions through carbon credit trading and taxes. According to researchers, as regulations increase, many reserves of oil, gas and coal now priced into company values may become impractical to exploit within 10 years.

In other words, the stock prices of many companies stand on the assumption that they eventually will mine or drill most of their energy reserves. However, as governments clamp down on carbon emissions, much of that oil, gas and coal may stay in the ground unused.

Carbon-Intensive Companies Already Overpriced

The "investment carbon risk" refers to a company's level of exposure to the two significant risks of climate change listed above. According to the University of Waterloo researchers, most carbon-intensive companies are already overpriced compared to the potential value loss resulting from climatic influences.

Investors are notorious for short-term thinking, but increasing risks from climate change are no longer a problem that is decades away. For example, coal usage is already in steep decline in the United States, according to Forbes. In 2005 it accounted for 50 percent of total power generation, but by 2015 that figure had dropped to only 33 percent.

There are several good options for investors looking to get out of carbon-intensive industries. These include well-established alternative energy industries such as solar and wind, along with riskier investments such as electric cars and carbon capture projects.

Market Solutions to Climate Change

Climate change might be an annoying subject for investors heavily invested in carbon-intensive industries. On the other hand, because of the potential consequences of those changes, the markets may become a force for good in fighting climate change.

Already, what researchers term "carbon-efficient" companies tend to outperform the high-emitting "carbon-inefficient" stocks. Talking to Wired, Soh Young In of Stanford noted that, "What we find is, carbon-efficient firms tend to be good firms in terms of financial performance and corporate governance."

Picking low-carbon stocks no longer means you'll have an investment portfolio without profits. Carbon-intensive industries are increasingly overpriced compared to their future potential. Not only does this provide an opportunity for smart investors, but it may also help fight the worst effects of climate change.

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