Introduction

This study explores the impact of transition climate policy risks on the stability of the US stock market, focusing on both pricing and volatility. Recognising a gap in existing literature, the research proposes a novel classification for transition climate policies and constructs risk indexes based on public attention. The analysis covers the period between 2000 and 2022, utilising a dataset of 143 climate-related policies retrieved from the International Energy Agency (IEA) database. This comprehensive framework aims to help regulators and investors understand how policy uncertainty influences financial stability and investment decisions.

Classification of transition climate policies

The research identifies five primary types of climate-related transition policies: carbon policies (CARBON), technology policies (TECH), climate solutions (SOL), environmental integrity (ENV), and climate finance. The latter group is further subdivided into financial incentives, financial disclosure, financial mobilisation, and financial accessibility and equity (ACCESS). For instance, carbon policies include regulations to quantify and limit greenhouse gas emissions, while technology policies focus on enhancing energy-use efficiency. Notably, the study identifies the 2022 Inflation Reduction Act as a significant multidimensional act that impacts all five categories, representing the largest US investment in climate change mitigation to date.

Construction of climate policy risk indexes

Climate policy risk indexes were constructed through textual analysis of public mentions across social media and news outlets. The researchers developed a climate policy vocabulary list (CPVL) to create monthly mention volume indexes (MVIs) from July 2010 to July 2023. These indexes serve as proxies for public attention. To isolate policy risk as an innovation or shock, the authors used residuals from ARMA models fitted to these MVIs. The analysis found that these indexes correlate well with existing measures, such as the Climate Policy Uncertainty (CPU) index, with correlation coefficients for environmental integrity and financial disclosure policies reaching 0.62 and 0.73, respectively.

Volatility analysis and empirical results

The empirical exercise employed augmented panel GARCH-X and EGARCH-X models to study 439 firms listed on the New York Stock Exchange (NYSE). The results indicate that transition policy risks are negatively priced in clean (low-carbon) returns and positively priced in carbon-intensive (emission) returns. Specifically, an increase in the CARBON_AGG index by one standard deviation is associated with a drop in NYSE stock returns of 648.11 basis points, while a similar increase in the TECH_AGG index causes a drop of 982.6 basis points. Furthermore, policy shocks were found to induce higher volatility in clean firms while promoting stability in carbon-intensive firms, contradicting the desired outcome of encouraging green investment.

Key findings regarding policy credibility

A central conclusion of the study is that US transition climate policies currently lack credibility and carry a predominantly negative public sentiment. The negative sentiment is highest for environmental integrity and carbon policies. This lack of credibility leads the public to believe that government actions are ineffective at promoting a sustainable transition to a green economy. The analysis also shows that the aggregate climate policy index can predict the US Climate Change Performance Index (CCPI); an increase in policy attention this year typically predicts a drop in policy performance the following year by 10.6 points, which was particularly evident during the 2017 to 2020 period.

Concluding remarks and policy recommendations

The researchers provide several recommendations for policymakers and regulators to improve the effectiveness of transition policies. Primarily, there is an urgent need to enhance the credibility of these actions to foster green investment. Policy designs should be accelerated to systematically promote better tools in climate change plans, ensuring they are perceived as effective and reliable. This can be achieved through the establishment of efficient internal supervision and guidance mechanisms that encourage financial institutions to disclose climate-related risks promptly. The study concludes that for the financial system to support a sustainable transition, policies must not only be implemented but must also be seen as credible and effective by the public and investors alike.