A sudden carbon tax causes widespread asset stranding, collapsing every sector.

A sudden convergence towards relatively high carbon prices, while justified from a climate perspective, may pose a threat to the stability of the financial system. As a result, central bankers have expressed deep concerns about the risk of financial contagion, driven by climate policy. Carbon pricing could lead investors to reevaluate a broad range of assets, of which many could become “stranded”. Given the considerable exposure of financial actors to carbon-intensive firms, beyond fossil fuel industries, and the strong interlinkages among such actors, there is high potential for a systemic risk. While central banks and other institutions in charge of financial stability have been investing important resources to refine their models of systemic risk and consider climate stress tests in their portfolio of macroprudential strategies, there is a need for empirical analyses, measuring whether and by how much investors reevaluate the value of stocks following a change in the probability of carbon pricing being implemented.

In this paper, we analyze the unique case of Washington state, where two carbon tax proposals were brought, two years apart, to the ballot box by two bottom-up initiatives. Furthermore, we leverage the different designs of these carbon tax proposals. I-732, rejected on the ballot in 2016, was designed as revenue neutral, with carbon tax revenues being compensated by lower sales taxes. I-1631, rejected in 2018, would have expanded the government’s budget. In particular, the carbon tax revenues would have been earmarked for environmental and social purposes.

We analyze the stock performance of Washington-based firms against their counterfactual and find important swings in the value of Washington-based firms following investors’ reassessment of the risks of a carbon price being implemented in the state. We identify significant reactions for both initiatives, suggesting that, if accepted, they would have led to a significant loss of market value for Washington-based firms. Consistent with its revenue-neutral design, we observe relatively smaller effects for I-732. Further, in both cases we observe important heterogeneity along the carbon-intensity dimension.

Hence, our findings support central banks’ calls for macroprudential policies to anticipate the implementation of carbon pricing, which remains the most cost-effective policy even in the presence of stranded assets. While our results do not provide a direct test for the effectiveness of such macroprudential policies, they suggest that even a moderate carbon tax, with limited jurisdiction, can lead to important readjustments to the stock market, especially for carbon-intensive firms. Hence, the implementation of carbon pricing at the scale required to deal effectively with climate change, and potential global coordination on carbon taxes, could lead to important shocks to the financial sectors, if preemptive measures are not implemented.