Equity Valuation and Climate Change
The thesis investigates whether climate risk influences equity value through the channel of the accounting system and, therefore, if investors adjust their relative valuation weights on different accounting variables with the exposure to climate risk. The thesis is motived by increasing global temperatures, which are thought to cause an increase in natural disasters, have a negative impact on economic growth, and produce instability in the financial system. The negative consequences of climate change make the issue an important one for legislators, regulators, standard setters, financial intermediaries, investors, and the general public. The literature suggests that climate risk has become material in its effect on capital markets through its impact on the economy via such channels as agriculture, labor productivity, investors moods, etc. However, few studies relating the long-run effect of climate risk on capital markets through the channel of the accounting system have been undertaken to date. This thesis therefore aims to contribute to an improved understanding of the way climate risk impacts on equity valuation though its effect on the reporting on the accounting aggregates of book value, earnings, and dividends.
The thesis adopts the accounting-based valuation theoretical framework of Gordon (1962) and Ohlson (1995). The elasticity of equity market value with respect to accounting variables is the main measure used to assess the impact of accounting on market values. The elasticities on the individual accounting variables reflect the relative importance capital market participants place on the corresponding accounting variable. In the value relevance literature, the book value of equity captures accumulative past information and is viewed as a backward looking, conservative, or pessimistic measure. Earnings is considered to reflect information about the future and is viewed as a forward looking, aggressive, or optimistic measure. If the elasticities of earnings are falling over time relative to the elasticities of book value of equity, it may indicate the market is paying greater attention to the latter compared to the former and being more pessimistic about equity values, due to the impact of increasing climate risk. The central hypothesis in the thesis is therefore that there is a positive association between the long-run elasticities of book value of equity and climate risk and a negative association between the long-run elasticities of earnings and climate risk.
The method used to test this hypothesis adopts a two-stage research design. The first stage estimates elasticities from annual cross-section regressions of U.S. data for the economy as whole and individual industries. In the second stage, a time series analysis regresses the elasticities obtained in the first stage on climate risk variables. The market value and accounting data is from a sample of 180,042 annual observations on listed U.S. firms over the period 1971 to 2017. The key climate risk measure is the annual global anomaly temperature over the same period.
The first stage results show that the models explain about 80% of the variation in stock price. The explanatory power holds for both the full sample of U.S. firms and for the subsample based on individual industries. The results demonstrate that book value of equity has a relative higher valuation importance than earnings during the period from 1971 to 2017 at both the U.S. and individual industry levels. Over the entire sample period, for the U.S. economy as a whole, market value increases by about 0.519% when the absolute value of book value of equity increases by 1%, and by 0.271% when the absolute value of earnings increases by 1%.
In the second stage, the results demonstrate that the signs of climate variables on the book value of equity and earnings are different. The results for the U.S. economy as a whole show that a 1oC increases in the global anomaly temperature is associated with an increase in the elasticity for book value of equity of 0.117 whereas a 1oC increase in the global anomaly temperature is associated with a decrease in the elasticity for earnings of 0.1698. Although the signs of these impacts are the same across different industries, the magnitudes vary across the industries.
The results thus provide evidence which is consistent with the hypotheses of the thesis. This thesis not only contributes to the studies in climate finance, environmental accounting, and accounting valuation, but also has important policy implications for accounting standard setters.