Does Regulatory Risk Affect Retail Investment Decisions?

Climate change is a challenge for both society and individuals. While many studies have shown that it affects the portfolio choices of institutional investors, less is known about how climate change affects the investment decisions of individual households. Does climate change affect how retail investors make portfolio choices? If so, through what type of mechanism? Our study Climate Change and Households’ Risk-Taking sought to answer these questions by focusing on regulatory risk, which is widely regarded as one of the most important components of climate risk.

In our study, we hypothesise that households with members who are employed in high-emission industries are incentivised to reduce their holdings of risky assets. This is because employees in these industries are expected to face a higher risk to their income, should the industry they work in be subject to new government regulations.

“We found that climate regulations may reinforce wealth inequality by deterring less wealthy households from participating in stock markets.”

Prof. Chanik Jo

To test this, we first looked at whether these high-emission households in the U.S. adjusted their investment portfolios following the adoption of climate change-related action plans in the state that they live in. For example, the state of Florida introduced in 2008 an energy and climate change plan that contained 50 policy recommendations aimed at reducing the emissions of greenhouse gases. Compared to other families, we found that the adoption of such a plan resulted in high-emission households reducing their holdings of risky assets by 15 percent.

We then found that if climate regulations become more stringent, this resulted in a more significant reduction in holdings of risky assets by high-emission households. The data showed that a one standard deviation increase in the level of stringency in enforcement by the U.S. Environmental Protection Agency led to a reduction of holdings of risky assets by 2.75 percent. Our results also showed that the adoption of climate-related action plans or changes in enforcement did not affect the investment choices of households that are not employed in high-emission industries.

Consistent with our previous findings that personal experiences of global warming can update people’s beliefs about climate change, we further found that when people experience natural disasters, this intensifies the effect of regulatory risks on the investment behaviour of high-emission households. This may be because they anticipate tighter regulatory enforcement in the future.

To mitigate their exposure to climate change risks, households may choose to leave a high-emission industry altogether. Our findings suggested that when climate change regulatory risks rise, there is a significant movement among households to work in companies that are considered as less polluting. Additionally, households that switch industries allocate more money to risky assets than those who stay in high-emission sectors.

An important implication of our findings is that climate regulations may have unintended consequences for households in high-emission industries. We found that these households tend to be less wealthy, younger, and less well-educated. As a result, climate regulation may reinforce wealth inequality by discouraging less wealthy households from taking financial risks, making it harder for them to accumulate wealth. However, this does not necessarily mean that society is generally worse off as a result of climate regulations. It is important that policymakers understand they must implement climate regulations in a manner that does not increase income risks for households employed in industries most affected by climate change regulations.