Environment-related stranded assets: What does the market think about the impact of collective climate action on the value of fossil fuel stocks?

Environment-related stranded assets are mainly those economic assets that may lose their value in response to environmental concerns. This study aims to develop new insights into environment-related stranded assets by extracting the US stock market view of how collective climate action may impact the value of fossil fuel stocks. To this aim, it adopts a forward-looking method in which an observed stock price is expressed as a probability-weighted average of its business-as-usual (BAU) and non-BAU values. It then expands the information set by options prices to recover the implied probability of climate action and estimate non-BAU and BAU values of stocks ex-ante. Overall, market estimates show a modest decrease in the price of fossil fuel shares at 4% on average, limited to a maximum loss of USD 100 billion. The reasons the potential loss is smaller than widely expected may include (i) investment horizon and ease of exit, (ii) the low probability of collective climate action and discounted-cash-flow impacts, (iii) the ownership of remaining reserves, (iv) the policy environment in the US. The paper further uncovers the distributions of non-BAU and BAU prices, revealing that the size of the carbon bubble has been decreasing since the Paris Agreement.