A Stern response to the bubble question

One year ago, the UK Treasury published the Stern Review on the Economics of Climate Change to intense media interest. Unlike previous surveys or popular accounts of climate change, Stern put a financial cost on both action and inaction in cutting emissions of greenhouse gases and moving to a low-carbon economy.

The work was of obvious relevance to the clean energy industry, which can't always convince potential customers that its products and services make economic sense, and generally hailed as good news. Specialist financial information provider New Energy Finance welcomed the Review as "good news for investors in the renewable energy and low carbon technologies sectors", highlighting Stern's calls for a stronger price signal for carbon emissions, greater international cooperation, and increased funding for low carbon R&D, "all of which will boost clean technology companies". Stock tippers on personal investment websites also saw the Review as positive news, posting 'Buy' recommendations on selected clean energy stocks.

At the time, there were concerns about a speculative investment bubble in the sector, manifest in both venture capital activity and in the valuations of publicly listed companies. Such concerns continue to date. While some bubble-like behaviour is hardly unexpected in an emerging and potentially revolutionary sector, a bubble and burst would be likely to cause medium-term financial problems that could seriously damage the prospects of clean energy companies.

From an economics point of view, it's virtually impossible to say whether a market is actually in a bubble situation until some time after it's burst - not a very useful situation for current investors. Previous bubbles have however demonstrated the role played by the media in feeding 'irrational exuberance' and inflating bubbles, with stock prices moving in an irrational fashion in response to high-strength but low-weight news events.

The release of Stern Review can be considered as such an event. The Review did not contain any new information about the nature of the climate change problem or related policy or technological issues. Despite the NEF's comments, it also contained nothing that could meaningfully affect the prospects of individual companies or the clean energy sector as a whole.

So could the stock price response of listed clean energy companies to the Stern Review and its accompanying media hype shed any light on the much-debated clean energy bubble?

That's the question I addressed in some recent research (completed as my dissertation for a Master's degree in Economics & Finance), using event study methodology to test the reaction of a portfolio of AIM-listed clean energy companies.

The findings were largely negative, which is fairly encouraging. A small minority of clean energy firms (notably those dealing in carbon trading) did show abnormal returns around the release of the Stern Review, but there was no significant portfolio-wide response that would indicate irrational exuberance among investors. There is no indication of a runaway bubble of the kind seen in the dotcom era, a period to which the current cleantech boom is sometimes compared.

Although the research methodology can't claim to be conclusive (and is relatively untested in its application to a non-company-specific event such as this), its conclusions are encouraging for the sector. Investor interest in clean energy, and the broader cleantech sector, appears to be rational and reasonable. That can only be good for its longer-term prospects.

The dissertation, 'Evidence for a speculative bubble in the clean energy sector: an event study', is available as a 1.2Mb PDF here.