How much of a firm’s value to society is hidden by traditional financial metrics? In this interview, Professors Robert Stambaugh and Luke Taylor dive into their study, “Carbon Burden,” which is part of the Jacobs Levy Center’s working paper series.
This paper aims to quantify the U.S. corporate sector’s carbon externality by computing the sector’s “carbon burden.” By putting a dollar value on corporate greenhouse gas emissions, this measure reveals just how much these hidden costs weigh on society. Their insights offer a fresh perspective on financial risk and the evolving responsibilities of today’s corporate leaders. Dive in to the full interview:
“Carbon burden” quantifies the financial impact of corporate emissions. Could you explain the basic concept behind this measure and how it deepens our understanding of a firm’s value to society?
Robert Stambaugh: A firm creates value for shareholders, employees, customers, and other stakeholders. In addition, the firm may help or harm third parties that have no direct connection to the firm. These effects on third parties are known as externalities, and they can raise or lower a firm’s value to society. Some of a firm’s societal value is readily observed, such as the firm’s value to shareholders, measured by its market value. Putting a dollar value on corporate externalities is more challenging.
We attempt to make headway by valuing a negative externality that clearly affects society at large – carbon emissions. Our valuation of this externality is what we call carbon burden. The valuation is forward-looking, because this externality has two key future dimensions: climate change depends crucially on the path of firms’ emissions in future years, and each year’s emissions have climate consequences for many subsequent years.
Luke Taylor: That’s right, thinking about the future is the key, just like when you’re thinking about a firm’s market value. Carbon burden and market value are actually similar concepts. A firm’s market value is the present value of its future dividends, whereas a firm’s carbon burden is the present value of the social costs from the firm’s future emissions. The two concepts measure different dimensions of a firm’s value to society, with market value belonging to shareholders and carbon burden representing a negative value borne by all.
In our data, we see some striking examples of how important it is to think about the future. Take American Electric Power (AEP) and NextEra Energy, two of the largest greenhouse gas emitters in the U.S. Their emissions levels were very similar in 2023, but we find AEP’s carbon burden is almost three times smaller than NextEra’s. Why? AEP was predicted to significantly reduce its emissions in the future, but NextEra was not. You’d miss that if you only looked at these companies’ recent emissions.
Your baseline estimate of the carbon burden is 131% of total corporate equity value, with 77% of firms’ burdens exceeding their market capitalization. What are the implications of these findings for investors? Can investors use carbon burden to evaluate a firm’s risk exposure?
Robert Stambaugh: There is surely a connection to financial risk. For example, consider the risk reflecting uncertainty about how firms’ carbon emissions may be taxed in the future. Firms with large carbon burdens are more exposed to this uncertainty, especially the firms also less able to pass the tax on to price-sensitive customers. Of course, beyond financial considerations, many investors have social and ethical concerns. The latter concerns create a potential conflict between maximizing market value, the traditional financial objective, and maximizing shareholder welfare, a broader objective that includes investors’ concerns about externalities. If an externality looms large relative to market value, as carbon burden does for many firms, then these two objectives can pose a significant conflict.
How do you think corporate leaders should balance these competing priorities, especially given the large scale of carbon externalities?
Robert Stambaugh: We don’t say how corporate leaders should do that, but we do note that this question has generated much debate elsewhere. The debate often centers around Milton Friedman’s famous “doctrine” that firms should simply focus on the financial side. For a collection of recent academic articles on this debate, I suggest interested readers have a look at Milton Friedman 50 Years Later.
What motivated you to develop the concept of a “carbon burden” to quantify the financial impact of corporate emissions?
Robert Stambaugh: In finance, we’re familiar with computing values of things by discounting dollar amounts in future periods back to the present. Such net-present-value (NPV) calculations are routinely applied, for example, to expected future financial payoffs on corporate actions such as capital expenditures. Our thought was simply to apply an NPV approach to valuing the future negative payoffs—climate damages—associated with corporate carbon emissions.
Luke Taylor: That approach lets us address a fundamental question in finance: How valuable are firms to society? Historically, the focus has mainly been on firms’ value to their shareholders.
We’re seeing more focus lately on firms’ value to other stakeholders, like customers and employees. Given the severity of the climate crisis, we wanted to connect this fundamental finance question to firms’ carbon emissions.
What surprised you the most about your findings?
Luke Taylor: We already knew that climate change is a big problem, but we were still shocked by how large our estimates of the carbon burden are. I didn’t expect firms’ negative value to society through their carbon emissions to be on the same order of magnitude as firms’ financial value to their shareholders. But that’s what we find. It’s another way of seeing how big a problem climate change is.
What would you like to see explored in future research in this area?
Robert Stambaugh: At the risk of sounding self-serving, we’d like to see continued research into the underlying ingredients of our measure. For example, two of those ingredients are, first, a forecast of carbon emissions in each future year, and, second, a forecast of how much future climate damage will be done per unit of emissions in a given future year. We very much stand on the shoulders of others, taking those forecasts from research overseen by various U.S. government agencies as well as a prominent financial firm. We hope such research will continue its progress and be joined by others.
Luke Taylor: Clearly, it would be good for society to reduce the carbon burden. We need continued research about which policies can reduce that burden fairly and efficiently.
Learn more about Professors Robert Stambaugh and Luke Taylor, co-director of the Rodney L. White Center for Financial Research.
View the study, “Carbon Burden” on the Jacobs Levy Center’s SSRN page. This paper was also co-authored by Professor Lubos Pastor of Chicago Booth School of Business.