IIMB, IIT Researchers make breakthrough in pricing ‘carbon risk’: Prof. Sankarshan Basu

IIMB, IIT Researchers make breakthrough in pricing ‘carbon risk’: Prof. Sankarshan Basu

Higher carbon footprint of companies gives higher returns to investors in the short term but could lead to heavy losses in the long term as governments impose regulations on greenhouse gas (GHG) emissions, according to a new mathematical analysis conducted by researchers from IIM Bangalore and IIT Guwahati.

The three-member research team comprises Prof. Sankarshan Basu, from the Finance & Accounting area at IIM Bangalore, Prof. Siddhartha Pratim Chakrabarty, from IIT Guwahati and Suryadeepto Nag, a BS-MS student from IISER Pune.

Investor awareness about impending regulations requiring firms to reduce their carbon footprint has introduced a carbon transition risk premium in the stocks of firms. On performing a cross-section analysis, a significant premium was estimated among large caps in the US markets. The existence of a risk premium indicates investor awareness about future exposure to low-carbon transition. A new measure, the Single Event Transition Risk (SETR), was developed to model the maximum exposure of a firm to carbon transition risk, and a functional form for the same was determined, in terms of risk premia. Different classes of distributions for arrival processes of transition events were considered and the respective SETRs were determined and studied. The trade-off between higher premia and higher risks was studied for the different processes, and it was observed that, based on the distributions of arrival times, investors could have a lower, equal or higher probability of positive returns (from the premium-risk trade-off), and that despite a fair pricing of the carbon premium, decisions by investors to take long or short positions on a stock could still be biased.

The paper is currently under review in the Journal of Sustainable Finance and the pre-print of a working paper version is available at https://arxiv.org/abs/2107.06518.