Climate change and asset prices - evidence on market inefficiency in Europe

There is an emerging consensus that the threat of global warming, as well as regulatory and market initiatives for the reduction of GHG-emissions, result in significant costs for companies today and in the future. The magnitude of these costs is unknown to investors and transforms climate change into a market-wide financial risk. An efficient stock market prices this risk and rewards investors with higher returns for assuming higher levels of systematic risk. The purpose of this thesis is to analyse the efficiency of stock markets with regard to climate change induced systematic risk. To that end, a Carhart 4 Factor Model extended for industry effects is applied to a sample of 433 European companies in the years 2005 to 2009. This research thus contributes to the understanding of the behaviour of stock prices towards the financial implications of climate change.

Results indicate that the stock market was inefficient in pricing all six proxies for climate change induced systematic risk applied in this study, i.e. a company's affiliation to the European Emissions Trading Scheme or high carbon industries, the existence of disclosure of GHG-emissions, the completeness of such disclosures, the absolute level GHG-emissions and GHG-efficiency. Persistent economically and statistically significant arbitrage opportunities exist when trading on publicly available information concerning these proxies. In this evidenced state of market inefficiency, investors are not rewarded for assuming higher levels of climate change induced systematic risk, but instead can achieve abnormal risk-adjusted returns by exploiting the inefficiently priced positive effects of (complete) climate change disclosure and good corporate climate change performance in the short-term. In conclusion, the financial market did not fulfil its role to correctly allocate ownership of the economy's capital stock with regard to the risk induced by the financial implications of climate change during the time period analysed in this study.