Stress testing equity markets with higher carbon prices

IN A NUTSHELL

• European insurance supervisors¹ have been highlighting the vulnerability of insurers to physical and transition climate risks, underscoring the need to strengthen consideration of climate risks and opportunities into insurers' governance and strategies.
• Carbon prices are a key transition risk for public equities, as countries are increasingly implementing carbon tax or trading policies², driven in part by the European Union's carbon border tax.
• This paper applies carbon price stress test scenarios to traditional and ESG equity indices.
• Our analysis concludes that higher carbon prices could significantly impact company equity value by -10% to -15% for the MSCI World index, based on a carbon price of USD 150/tCO₂ or USD 300/tCO₂.
• While this impact is consistently negative across indices, it is less pronounced on ESG indices.
• Another approach to hedge against carbon price equity risk is to consider investing in European carbon allowances.

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1 Bank of England 2021; EIOPA 2022; APCR 2023-24
2 HSBC (October 2023)-Carbon tax or trading policies are being created or strengthened in countries such as Australia, Brazil, China, India, Indone- sia, Taiwan, Turkey, UK, and Vietnam. Some US Democrats & Republicans have separately proposed a carbon border tax.