The impact of carbon risk on stock returns: evidence from the European electric utilities

ABSTRACT

The decarbonization process has made obsolete the traditional value-creation model of companies operating in the electricity sector, particularly affecting those with a greater share of fossil fuels in their energy mix that have been forced to write down their carbon-intensive activities with a negative impact on operating income, equity and leverage. Institutional investors have a significant exposure to equity and debt of European Electric Utilities: if the transition process towards a low-carbon system is faster than expected, the risk that these weaknesses may spread across the financial system shouldn’t be underestimated. Analyses based on risk-premium factor models show that there was a significant low-carbon premium during the years in which the decarbonization process accelerated; in the period considered, an investment strategy that focused more on low-carbon companies would have delivered higher returns without modifying the overall risk profile.

KEYWORDS:

• Carbon risk
• climate change
• factor models

JEL Classification:

• C58
• G11
• Q54

Disclosure statement

No potential conflict of interest was reported by the authors. The views expressed in this paper are those of the authors and do not necessarily reflect those of the Bank of Italy.

Notes

1 In the text we use this term as an equivalent to climate-related financial risk, used by the FSB-established TCFD.

2 The classification presented is borrowed from the 2015 Report of the UK Prudential Regulation Authority. The same classification is also used in the TCFD Final Report.

3 Faiella and Natoli (2018).

4 On the consequences of an increasing energy expenditure see Faiella and Mistretta (2015) for firms and Faiella and Lavecchia (2015) for households.

5 Exxon is suspected of having misled the public on the link between fossil fuels use and climate change (http://www.bloomberg.com/news/articles/2016-09-07/will-exxonmobil-have-to-pay-for-misleading-the-public-on-climate-change). According the prosecutors the company not only failed to fulfill its social duties (i.e. a correct communication with the public), but its omissions could be considered a fraud to the investors thus violating the fiduciary duty obligations that bind a company and its investors

6 The TCFD report has been released in June 2017. According to the report, reporting entities: 1. should provide climate-related financial disclosures in their mainstream financial filings, on a voluntary basis and pondering the costs and benefits of this additional reporting; 2. should consider risks and opportunities entailed by climate change. 3.should disclose climate-related financial information considering four areas: Governance, Strategy, Risk Management and Metrics and Targets; 4. should use scenario analysis, including a 2 degree scenario (the reference target of the Paris Agreement).

7 Villeroy de Galhau (2015).

8 Prudential Regulation Authority (2015).

9 ESRB ASC (2016).

10 Dicou et al. (2016). The work highlights that ‘there is a strong consensus that inaction is no longer an option’ and, as a consequence, the Dutch Central Bank has decided to receive regular reports from the financial system on direct exposure to the energy sector.

11 Regelink et al. (2017).

12 The NGFS published on 11 October 2018 its first Progress Report (2018) summarizing the preliminary findings of its stock take exercise of national, regional and international initiatives

(https://www.banque-france.fr/sites/default/files/media/2018/10/11/818366-ngfs-first-progress-report-20181011.pdf).

13 United Nations Environment Programme – Finance Initiative, is a partnership between the United Nations Environment Program (UNEP) and the financial sector created in 1992 with the mission of promoting sustainable finance.

14 Beyond EIB, other issuers include many international organizations such as the European Bank for Reconstruction and Development, the Asian Development Bank, the African Development Bank and the Nordic Investment Bank

15 The 60 stock exchanges currently part of the SSE are committed to increasing the transparency requirements in terms of ESG.

16 With regard to other economic activities, manufacturing activities produce 19% of emissions, households 19%, agricultural activities 12%, transport 11%, services 11%, mining activities 2% http://ec.europa.eu/eurostat/statistics-explained/index.php/Greenhouse_gas_emissions_by_industries_and_households.

17 Eurostat ‘Electricity Statistics 2016 (in GWh)’, http://ec.europa.eu/eurostat/statistics-explained/index.php/File:Electricity_Statistics_2016_(in_GWh)-T1.png

18 The STOXX Europe 600 Index includes other companies of the Utilities sector, which are excluded as not having a share of revenue above 10% from the electric generation business.

19 In this study we used data of GHG emissions classified as Scope 1 and Scope 2 by the GHG Protocol. Scope 1 are direct emissions generated from sources owned or controlled by the company. Scope 2 are indirect emissions related to sources owned or controlled by another companies, such as the emission related to the electricity bought from third suppliers.

20 The companies were assigned to the LC (HC) group if for at least five of the nine years analyzed they had a lower (higher) intensity than the median of the sample.

21 European Environment agency (2017).

22 Our elaborations on Eurostat data http://appsso.eurostat.ec.europa.eu/nui/show.do?dataset=nrg_113a&lang=en.

23 Silver (2017).

24 The rapid decrease in the capacity utilization rates (load factor) has increased the competitiveness of coal plants (whose price has halved in the period 2011–2014) compared to gas-fired power stations. Vahlenkamp and Leger (2014).

25 The European emissions trading system sets a ceiling at the level of total greenhouse gas emissions of around 12,000 energy-intensive plants (1,000 in Italy), giving the participants an initial quota of permits. Companies can buy or sell emission allowances on an organized market depending on whether they are above or below pre-established ceilings. The prices of permits, after reaching their maximum value in the summer of 2008 (€ 28 per tonne of greenhouse gases), have plummeted, stabilizing in recent years at around € 6 per tonne.

26 The electric generation with renewables does not have costs of fuel and is therefore offered at a price close to zero, displacing the thermoelectric technologies and pushing the marginal plant used (which determines the total price for that time slot) to offer energy to lower and lower prices thus reducing the break-even price compared to the other time slots. This phenomenon leads, other things being equal, to a reduction in the peak prices with the increase in the share of renewables in the generation mix.

27 These factors were also considered in the revision of the international financial reporting standards (IFRS) for the utilities Welter et al. (2011).

28 According to a study by McKinsey digital optimization may raise the profitability of the utilities sector by 20–30% (Booth, Mohr, and Peters 2016). Some examples of applications of artificial intelligence are described in the review of Mellit et al. (2009).

29 A rather rough indicator, represented by the ratio between the total turnover (in millions of euros) and the energy produced (GWh) for each of the two groups, shows an average annual value of 0.24 for the LC and 0.30 for the HC, with a variance contained within 0.1% for both groups. These gauges should however be considered cautiously as they are influenced by the many activities operated by the EEU, encompassing not only in the power generation process but also in other production steps (eg network management, distribution and sales, ancillary services).

30 Eurelectric Report (2015). According to a report by Ernst & Young (Catoire and Coneybeare 2014), 66% of the 2013 impairment has been relative to the generation process and 64% of the latter referred to conventional sources (coal and gas) and 10% to nuclear sources.

31 Although Italy recorded a significant drop in electricity prices, they nevertheless remain higher than other continental countries (in 2015 € 52 / MWh in Italy versus 50 in Spain, 48 in the UK, 38 in France and 32 in Germany).

32 European Commission (2016) and Eurostat (2016).

33 The simple average of the balance-sheet ratios was used instead of the weighted average, in order to avoid the preponderance in the signal of the major companies.

34 Acronym di ‘Earnings Before Interest, Taxes, Depreciation and Amortization’.

35 Bodie, Kane, and Marcus (2004).

36 The differences in the equity yield and debt yield for the EEUs belonging to different EU countries also contributed to the WACC differential of the two groups (that was mainly due to the government yield spread). In the HC group there is in fact a prevalence of companies from the countries of continental Europe.

37 Vahlenkamp and Leger (2014).

38 Calculated as net debt on equity.

39 The bond issued, for example, by Endesa in 2016, was placed on the market at yield rate of 0.3%.

40 The research refers to a sample of 12 European electric utilities between 2005 and 2007.

41 The research refers to a sample of 22 European electric utilities between 2005 and 2008.

42 The research refers to the period between 2005 and 2010, the considered electric utilites have been clustered in 3 buckets depending on their carbon intensity (CO2 emission per unit of energy produced).

43 The authors analyze a sample of 65 firms form multiple sectors.

44 The authors considered a sample of 2.114 firms located in the US, Europe and Asia-Pacific operating in different sectors in the period between 2008 and 2015.

45 The BMG factor have been calculated as a monthly return of a zero-exposure portfolio built with long positions in firms heavily exposed to carbon risk and short positions to the ones with a small exposure. The carbon risk exposure have been measured through a composite index obtained with a scorecard which contained several features related to carbon risk, among others: GHG emissions, energy consumption and investments in technology associated with emission reduction.

46 Results refer to a sample of 2.268 large and listed firms accounting for 85% of global market cap in the period 2008–2015.

47 The authors measure carbon intensity as a ratio between Scope 3 GHG emissions and dollar revenues.

48 The grouping criteria is slightly different with respect to the financial analysis of the previous chapter.

49 Fondazione per lo sviluppo sostenibile (2016).

50 The analysis evaluates the profitability of the Moorburg plant built in 2009 by Vattenfall. The two scenarios considered assume in 2030 a different degree of use of the plant (80 percent in case of moderate decarbonization, 60 percent in case emissions reduction) under various quotations of coal and emission permits. Carbon Tracker (2015).