Carbon pricing is the most cost-effective policy to address the climate challenge. Following the Paris Agreement, a first acceleration in the implementation of carbon pricing schemes has been observed and we can expect a further acceleration over the next few years, as countries ratchet up their climate goals under their Paris commitments.

The authors of this paper show that while a convergence towards relatively high carbon prices is more than welcome from a climate perspective, central banks and other agencies responsible for financial stability may need to play close attention to such development. Without macroprudential policies, any sudden increase in carbon prices can lead to major shocks to the stock market. Some assets will lose part of their value, others all of it, and hence become ‘stranded’. If the markets are not ready to absorb the shock, a financial crisis could follow.

The authors analyse stock market reactions to the rejection of two carbon tax initiatives by voters in Washington state in the United States. They find that these modest policy proposals with limited jurisdiction caused substantial readjustments on the stock market, especially for carbon-intensive stocks, following investors’ reassessment of the risks if a carbon price were implemented. They also leverage differences in the design of both carbon tax initiatives and find smaller stock market reactions for an initiative that was designed as revenue neutral compared with an environmental spending initiative (in the style of the Green New Deal).

The findings support the inclusion of transition risks in macroprudential policymaking as pre-emptive measures to avoid a financial crisis. Implementing such macroprudential policies would ensure that the path towards a global carbon price is not delayed by concerns about financial stability. Climate-stress tests and mandatory carbon disclosure represent the main responses to such concerns.

Key points for decision-makers

  • Fifty-seven jurisdictions worldwide now price carbon, covering about 20 per cent of global greenhouse gas emissions (World Bank, 2019). The World Bank’s High-level Commission on Carbon Prices has called for a global carbon price in the order of US$40 to $80 per tonne of carbon dioxide (Stiglitz et al., 2017).
  • The authors analyse stock market reactions to the largely unexpected defeat of two carbon tax initiatives in Washington state, Initiatives I-732 (rejected in 2016), and I-1631 (rejected in 2018).
  • Initiative I-732 was to be a revenue-neutral reform, while I-1631 was to take the form of an environmental spending bill, along the lines of the currently debated Green New Deal.
  • The authors find that both events led to significant readjustments in the value of Washington-based firms. The firms in the authors’ sample were downstream firms that use energy as an input to their production function. This sample allows the authors to investigate the full extent of systemic risk.
  • The adjustments were stronger for carbon-intensive stocks, and tended to be stronger for I-1631 than for the revenue-neutral I-732.
  • These results have crucial implications for designing cost-effective policies in the face of climate change, showing in particular that even a relatively modest policy with limited jurisdiction can represent an important shock to the stock market. The concern about systemic risk in the case of a coordinated implementation of ambitious carbon prices across countries therefore seems justified.
  • The analyses support central banks’ calls for macroprudential policies to anticipate the implementation of carbon pricing, which remains the most cost-effective policy for tackling climate change, even in the presence of stranded assets.
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