Perception is an independent link and triggers rapid devaluation.

Stranded asset risk is relevant for the energy sector and beyond. Most fossil energy assets are long-lived; they usually require a large initial investment, but have relatively low operating costs. Davis and Socolow (2014) show that expected future cumulative emissions from the existing infrastructure of the global power sector have increased dramatically in the last decades. Such long-term investments have the potential to “lock in” carbon-intensive technologies for a long period of time (Erickson et al., 2015).42 Calculations by IEA (2013) and Pfeiffer et al. (2016) conclude that the “2° capital stock” will already be reached in 2017. Investments in fossil capacities after 2017 are inefficient: they lead to “both larger carbon lock-ins and higher short-term emissions that need to be compensated by deeper emissions cuts in the long run” (), increasing the cost of climate change mitigation. Moreover, in order to achieve emission cuts in such a scenario, fossil assets need to be stranded. provides a conservative estimate that the energy industry faces sunk costs of $ 120 billion due to fossil fuel plants being retired early, even if action to achieve the 2°C goal had started in 2012. For a scenario of delaying climate action until 2030 (and using a different methodology), estimates stranded assets of $ 1.9 trillion in electricity generation, and an additional $ 7 trillion in upstream energy infrastructure (mostly oil production). This is approximately equivalent to 3.5% of global income, and implies a risk not just for the obviously affected energy industry facing sunk costs: international organizations, financial institutions and regulators are increasingly concerned about the “transition risk” of climate policy, especially about a sudden re-pricing of assets.43 A sudden devaluation of energy companies will occur only if expectations were not adjusted in accordance with the risk of asset stranding. Sudden changes in the stringency of carbon policies, or expectations in the presence of tipping points can lead to abrupt repricing of fossil fuel assets. Given energy companies' size and interrelation with the rest of the economy, policymakers may regard energy companies as “too big to fail.” For this and other political economy reasons,44 policymakers may opt for compensation policies, and investors may expect them to do so. Compensations, then, are almost a self-fulfilling prophecy: if they are expected, they will be necessary in order to avoid larger shocks.45 Therefore, understanding the interaction between policy making and investors’ expectations is essential for the design of climate policies. Our results suggest that early and credible commitment to climate policies and whether they involve compensation payments or not is crucial. Such clear signals to financial markets can avoid a disruptive and unorderly energy transition and macro shocks, while directing capital towards climate-friendly technologies. We believe that further research in similar contexts can help to generalize these results, or to identify the important factors in the formation of expectations regarding climate related risks.