Tail risk in the fossil fuel industry: an option implied analysis around the unburnable carbon news

Abstract

This paper studies the option implied tail risk in the oil and gas industry around the unburnable carbon news of April 2009. It was arguably the first science news amplified by the media that stated that the value of the oil and gas industry is stranded. After controlling for the level of proved fossil fuel reserves and the return drop on the event day, I find that large and small companies are perceived as equally exposed to carbon risk. However, the risk persists only in some oil and gas firms. As expected, the level of fossil fuel reserves increases risk.

Financial effects of carbon risk and carbon disclosure: A review

“…To proxy for a firm's carbon risk, Herbohn et al (2019) focus on the reporting of a firm around bank loan announcements. Neudorfer (2021) studies the heterogeneous tail risk response of fossil-fuel companies around the unburnable carbon news, which is claimed as the first climate science news regarding the stranded fossil fuel industry (Meinshausen et al, 2009). 18 Related to the more ambitious climate target announcement (the Paris Agreement), Monasterolo and De Angelis (2020) analyse whether stock markets price this climate announcement by investigating the change in the systematic risk based on low-carbon and carbon-intensive indices.…”

“…Both Ilhan et al (2021) and Neudorfer (2021) explore the impact of carbon risk on the firm's tail risk using option measures. Ilhan et al (2021) investigate the climate policy uncertainty of S&P 500 firms in the options market.…”

“…Meinshausen et al (2009), claimed to be the first climate science news article relating to the stranded fossil fuel industry, was published on 30 April 2009. The release date of this pivotal study is designated the ‘event date’ for later studies such as Neudorfer (2021). Neudorfer (2021) estimates tail risk using two option‐implied measures: the first being the option‐implied conditional value at risk (CVaR) based on industry returns, extracted from put options of the exchange‐traded fund; the second being the implied 5% value at risk (VaR 5% ) based on the firm level's call options.…”

“…This proxy likely captures relevant policy or regulatory risks a firm is exposed to, as most events indicate new policies in place or changes in the existing policy. These policy changes require businesses to adjust and improve their strategies to ensure regulatory compliance (e.g., Herbohn et al, 2019; Neudorfer, 2021; Nguyen & Phan, 2020). The fourth and final proxy is related to carbon emission scores or carbon performance ratings (Ganda, 2018; Qian et al, 2020; Zhou, Zhang, et al, 2018).…”

“…This method is also used in an unpublished study byNguyen et al (2020).18 Meinshausen et al (2009) conduct a comprehensively probabilistic study and make a quantifying GHG emission target to limit global warming to 2°C by 2050. Its published date is used as the news day inNeudorfer (2021).…”