Recent years have seen a growing divergence in how central banks approach climate change. For instance, while Jerome Powell, Chairman of the Federal Reserve System, underscores that the Fed doesn’t view itself as a “climate policymaker,” the Bank of England and the European Central Bank have been more proactive, advocating for an economy-wide transition to climate neutrality.1,2 Central banks entrée to climate policy raises the question: Does monetary policy influence the path to net-zero emissions?
Monetary policy can affect how firms transition to a low-carbon business model in numerous ways. A tighter monetary policy stance increases funding costs, which suppresses corporate investment and slows down the replacement of existing assets. This may affect the valuation of firms with higher carbon emissions relatively more for two reasons. First, firms with higher emissions may be more affected by tighter funding conditions because they have greater needs to replace polluting assets. Second, firms may decide to delay transitioning. With net-zero targets gaining traction, firms that delay transitioning retain a greater exposure to climate-related technological risks, such as stranded assets. Alongside technological risk, slower capital replacement also means that firms will retain their current exposure to climate regulatory risks, such as emissions standards and carbon taxes, and climate-related market and reputation risks, such as changing preferences or increasing awareness about climate change by investors, consumers, and suppliers. As outlined in the Task Force on Climate-Related Financial Disclosures, these risks will likely have a financially material impact. However, given its medium to long-run nature, it is empirically challenging to evaluate whether monetary policy affects how firms transition.
Our recent research delves into this issue by examining stock market responses around the Federal Open Market Committee (FOMC) announcement dates. Stock market responses provide a forward-looking, market-based assessment of how monetary policy affects corporate carbon transition risk. Based on the theoretical arguments outlined above, we argue that a restrictive monetary policy stance heightens firms’ carbon transition risk and increases the transition cost, whereas an accommodative stance eases these costs. If monetary policy shocks amplify the cost of transition, firms with greater exposure to transition risk should have a higher stock price sensitivity to monetary policy shocks. To capture a firm’s exposure to carbon transition risk, we use firm-level carbon emissions from Trucost, as a higher level of emissions implies a greater exposure to climate-related shocks and a greater need to transition. We focus on scope 1 emissions, which are emissions directly and physically emitted by a firm.
The Main Findings
Our main finding is that the sensitivity of stock price reactions to monetary policy shocks is higher among high-emission firms. Our headline result shows that a one-standard-deviation increase in the log of a firm’s total scope 1 carbon emissions is associated with a 0.487 to 0.628 percentage points stronger stock price increase (decline) to a surprise 25bps monetary policy easing (tightening). The effect is economically significant: It translates into a one-sixth amplification of the average full-sample response.
Given the multi-faceted nature of carbon transition risk, we examine which aspects drive our headline results. We find that climate change-related technology risk (as measured by capital intensity) and regulatory risk (as captured by textual analysis-based measures) are key drivers. However, we find no clear evidence on the role of shareholders (as measured by the proportion of socially responsible institutional investors) or product market competition (as measured by product market power and product substitutability). Furthermore, we find that the headline result is also driven by firms that are (perceived to be) less equipped to transition (as measured by the lack of an abatement plan in place and low ESG ratings).
Did the Market Get It Right?
To determine whether these stock market responses align with real-world outcomes, we leverage recent advancements in a methodology known as instrumental-variable local projections. Based on our approach, we estimate that an instrumented 25bps increase in the 1-year Treasury rate results in a decline of up to 3% in firm-level scope 1 emissions after two years. This decline in emissions appears to be entirely driven by lower output. While we find a concurrent decline in investment and sales in response to monetary tightening, there is no concurrent decline in emissions intensity. Over longer horizons (3 to 4 years), emissions intensity slightly increases. This suggests that while monetary policy tightening reduces emissions due to its negative effect on output, it also results in lower carbon efficiency down the road, as firms are likely to forgo investments in abatement and low-carbon technologies.
We then examine whether the effect of monetary policy on corporate emissions affects large emitters differently. Notably, based on Trucost data, large emitters have negative emissions growth, i.e., on average, large emitters are lowering carbon emissions. However, we find that when the level of interest rates is high, emissions growth among high-emission firms increases relative to low-emission firms. These findings suggest that while high-emission firms reduce emissions relative to low-emission firms on average, these emissions-reduction efforts are hampered by a tighter monetary policy stance.
The implications of our findings are far-reaching. In summary, our stock price sensitivity analyses and local projections paint a consistent picture: Investors recognize that transitioning to a low-carbon business model is cheaper when funding conditions are accommodative but costlier when monetary policy is restrictive. Therefore, tight monetary policy hampers firms’ emissions reduction efforts, leaving high-emission firms more exposed to climate transition risk. These effects are reflected in stock prices on FOMC announcement dates, resulting in an amplified response among high-emission firms. Over the medium run, despite high-emission firms bringing down emissions more relative to low-emission firms, this gap in emissions growth shrinks when monetary policy tightens. Our results indicate that monetary policy affects the transition to a low-carbon economy, regardless of whether a central bank embraces a climate mandate.
Robin Döttling is an Assistant Professor at the Finance Department at Rotterdam School of Management, Erasmus University Rotterdam
Adrian Lam is a Clinical Assistant Professor of Finance at the University of Pittsburgh.
This post was adapted from their paper, “Does Monetary Policy Shape the Path to Carbon Neutrality?” available on SSRN.