What happens if policymakers are forced to "stamp on the brakes" and force carbon prices higher?

Financial markets have typically worked on the assumption that climate policy would be gradually tightened over a period of several years, if not decades. This is known as the “slow policy ramp”.

Too high a carbon price at the outset for example, many reason, will be politically untenable. Instead the assumption is that carbon prices will gradually rise over several years. This is the familiar playbook seen across carbon trading schemes and carbon taxes where free allocations and numerous exemptions are the initial conditions.

But what if a more extreme scenario occurs, one in which climate change occurs much faster than people expect with more extreme adverse consequences? The risk in putting off action in the face of economic and geopolitical concerns is that we only put off the required reductions but leave us even less time to achieve it. Time compression may mean that the policy response required is much more extreme than the “slow policy ramp” built into many financial models.

What if, instead of a gradual ramping up in the pressure, policymakers are forced to “stamp on the brakes”?

Analysis published last year by Kempen Capital Management estimated that global equity market valuations would fall by about 4% if scope 1 and 2 emissions were suddenly hit by a $75 per tonne carbon tax (equivalent to €68 per tonne as of today).¹

Not so bad you might think.

It gets worse if indirect emissions, known as scope 3, were included in the $75 per tonne tax. In that event global equity markets would potentially suffer a 20% drop. European equities would suffer less than their US counterparts.

But what if policymakers are forced to “stamp on the brakes” and impose a much higher carbon tax? Kempen’s analysis found that if a carbon tax of $150 per tonne global markets could fall by as much as 41%.

Low carbon equities would still see a hit to their valuations in all scenarios, but significantly less than the global and regional (Europe and the US) averages. According to Kempen the risk of policymakers stamping on the brakes has not been priced in, estimating that adopting a climate-positive portfolio could add 20% to returns over the next ten years, even compared to a lower carbon / sustainable equity approaches. 

Kempen suggests that investors could achieve this by reallocating existing equity exposure to lower carbon or climate transition tilted equities and seeking out opportunities to benefit directly from the transition economy such as clean energy, clean water, food supply and farmland.

One asset Kempen does not mention is carbon markets. That seems like a mistake, especially if governments pursue geopolitical and economic ambitions at the expense of climate policy.

It is difficult to know how and when. But later this decade that could set up a situation where everyone is even more short carbon than they are now. That may bring about the exact situation Kempen outlines in their modelling where carbon taxes and carbon prices are forced to increase very fast and to much higher levels than would be considered economically and politically acceptable today.

The carbon price is an inflation hedge

1. This assumes that firms balance sheets take the hit and nothing is passed onto consumers. In reality, much of the burden will be shifted to consumers which through inflationary pressures creates its own headwind to equity market performance.