Despite the urgent need to address climate change, fossil fuels still dominate our energy landscape, driving high carbon dioxide (CO2) emissions and accelerating global warming. The International Energy Agency (IEA) warns that fossil fuel consumption must drop by over 25% this decade and by 80% by 2050 to keep global temperature rises below 1.5°C (IEA 2023). The 2015 Paris Agreement set ambitious targets to limit global temperature increases to below 2°C and preferably 1.5°C, posing a significant challenge for fossil fuel firms, while forcing them and investors to navigate an increasingly complex and uncertain market and regulatory environment.
The prospect of stricter climate regulation prompts critical questions about how firms will adjust their strategies and investment decisions. Oil and gas companies face high transition exposures because of substantial risks of lower demand, rising productions costs, and the potential for devaluation of their physical and financial assets. Reducing fossil fuel extraction could also hit fossil fuel-producing economies hard, impacting their economic growth, trade balances, and various domestic sectors (Bems et al. 2023). Therefore, understanding how fossil fuel companies have shifted their investment patterns since 2015 is crucial.
Evaluating the impact of climate policies on fossil fuel investments is complex
Firms might respond differently to climate change policies: some may scale back operations and withdraw from exploration and extraction due to expected declines in demand and rising production costs from carbon taxes. On the flip side, others might ramp up investment to exploit resources and secure profits before more stringent regulations hit – a phenomenon known as the ‘Green Paradox’ (Sinn 2008, 2012). Recent research by Bogmans et al. (2023) offers insights into this dynamic, suggesting that fossil fuel firms have pre-emptively scaled back investment in anticipation of lower demand driven by the Paris Agreement, using a differences-in-differences estimation approach that compares fossil fuel firms with those in other industries. However, our re-examination of the issue using an alternative methodology indicates a different outcome. We argue that the significant drop in oil prices coinciding with the Paris Agreement likely influenced investment decisions in the fossil fuel sector differently than in other sectors (Figure 1). Specifically, lower oil prices squeezed profitability and investment in fossil fuel firms, while reduced energy costs likely supported investment in other industries. This raises questions about the validity of the control group in the aforementioned study and motivates our strategy.
To better understand how fossil fuel firms are reacting to anticipated climate policies, we employ a differences-in-differences approach on global fossil fuel firm-level data from 2010 to 2021. This methodology leverages the Paris Agreement in 2015 and, crucially, intra-sector variation in climate change exposure within the fossil fuel industry (see Adolfsen et al. 2024 for the full specification). By doing so, we establish a control group equally affected by the fall in oil prices that took place around the Paris Agreement. Our hypothesis posits that firms with higher exposure to climate change are more likely to anticipate larger impacts from regulatory changes aimed at addressing climate change than those with low exposure. Therefore, they are more likely to incorporate the expected changes in climate policy into their investment strategies.
Figure 1 Fossil fuel investment and oil prices
Notes: Average ratio of capital expenditures to property, plant and equipment by fossil fuel firms over the sample period from 2010- 2021. Monthly Western Texas Intermediate spot oil prices are plotted as reference.
To identify variations in climate change exposure, we utilise a text-based measure developed by Sautner et al. (2023). This metric captures the extent to which firms’ management and financial analysts discuss climate change aspects in earnings calls. Essentially, it reflects management’s perception of their firm’s exposure to climate policy changes, making it suitable for analysing investment decisions, which are ultimately influenced by management and shareholder expectations.
Fossil fuel firms with high climate change exposure increased brown investment after the Paris Agreement
Our study reveals two main findings. First, fossil fuel firms with high climate change exposure responded to the Paris Agreement by increasing investment relative to firms with low exposure. Specifically, investment of high-exposure firms was between 30-40% higher than investment of low-exposure firms in the period after the Paris Agreement (Figure 2).
This supports the Green Paradox prediction, which suggests that these firms initially intensify extraction in anticipation of stringent carbon policies. In fact, a counterfactual exercise indicates that the investment ratio in these high-exposure firms could have increased by up to 4 percentage points between 2010 and 2021 if macroeconomic conditions and oil prices had remained stable (Figure 3).
Figure 2 Investment response to expected climate policies
Note: the figure reports results from our baseline differences-in-differences estimation around the 2015 Paris Agreement. The dependent variable is the log investment ratio. We repeat the baseline estimation but without firm and time fixed effects and without firm and time fixed effects as well as firm level control variables. See Adolfsen et al. (2024) for details.
Figure 3 Investment under stable macroeconomic conditions and oil prices
Notes: This figure represents a counterfactual exercise, estimating the investment ratio for low versus high climate change exposure firms under the assumption of constant oil prices and GDP forecasts. See Adolfsen et al. (2024) for details.
Second, the increase in investment primarily stems from firms focused on fossil fuel extraction rather than those diversifying into alternative investments. It indicates that firms continued their traditional business models rather than investing in a transition to renewable energy sources. Additionally, these firms also increased emissions relative to less exposed counterparts, suggesting that investment was not aimed at reducing the carbon intensity of production processes.
Effects are stronger in Europe
We conducted our baseline analysis with subsamples of European and North American firms, an important distinction given differences in uncertainty about climate policy between the two regions. In the US, uncertainty about implementation of climate policy targets is significant (Nowzohour et al. 2022) amid varying levels of participation in the Paris Agreement under the last three US presidents (Victor et al. 2022), whereas expectations about compliance with the Paris Agreement are generally higher in Europe. Since the Green Paradox is driven by expectations about future climate regulation, we expected stronger effects in Europe. We find a positive impact of higher climate change exposure on investment on both continents, with the effect being about twice as large in Europe compared to North America (Figure 4).
This evidence supports our findings, namely that Green Paradox mechanisms have dominated the response of the fossil fuel industry to the Paris Agreement so far.
Figure 4 Investment response in Europe and North America
Notes: The figure reports results from our differences-in-differences estimation around the 2015 Paris Agreement. The dependent variable is the log investment ratio. We repeat the baseline estimation for subsamples of European and North American firms and report the estimated effect of the Paris agreement on firms that are relatively more exposed to the Paris Agreement relative to firms with low exposure.
Navigating climate policies and the energy transition: A balancing act
Our findings carry significant policy implications. The Paris Agreement marked a milestone in the global effort to combat climate change, but its success hinges on the implementation of well-designed and timely policies. Without concrete measures, the transition to a greener future could lead to unintended negative consequences.
First, international climate agreements like the Paris Agreement must be underpinned by carefully planned policies that are implemented promptly. Delays or ambiguities in these policies could perpetuate or even heighten reliance on fossil fuels during the transition to greener energy. Such ongoing dependence would offer little incentive for fossil fuel firms to shift towards sustainable business models.
Second, in the absence of immediate and well-crafted policies, governments might find themselves compelled to enforce abrupt and stringent measures as climate deadlines approach. These last-minute actions could lead to higher volatility in energy prices and economic disruptions. This scenario underscores the delicate balancing act that governments must navigate: advancing the climate change agenda while preventing spikes in energy costs and minimizing economic setbacks during the transition period.
Striking this balance is crucial for ensuring a stable and sustainable energy future.
References
Adolfsen, J F, M Heissel, A-S Manu and F Vinci (2024), ”Burn now or never? Climate change exposure and investment of fossil fuel firms”, ECB Working Paper No. 2945.
Bems, R, L Boehnert, A Pescatori and M Stuermer (2023), “Reducing fossil fuel extraction may imply persistent negative effects for fossil fuel-producing economies”, VoxEU.org, 11 July.
Bogmans, C, A Pescatori and E Prifti (2023), "The impact of climate policies on oil and gas investment”, VoxEU.org, 29 October.
IEA (2023), “Net zero roadmap, a global pathway to keep the 1.5ºc goal in reach”.
Nowzohour, L, M van den Heuvel and J Noailly (2022), "A novel news-based index of environmental and climate policy uncertainty”, VoxEU.org, 4 November.
Sautner, Z, L Van Lent, G Vilkov and R Zhang (2023), “Firm-level climate change exposure”, The Journal of Finance 78(3):1449–1498.
Sinn, H-W (2008), “Public policies against global warming: a supply side approach”, International Tax and Public Finance 15: 360–394.
Sinn, H-W (2012), The green paradox: a supply-side approach to global warming, MIT Press.
Victor, D G, M Lumkowsky and A Dannenberg (2022), “Determining the credibility of commitments in international climate policy”, Nature Climate Change 12: 793–800.
