Carbon intensity and the cost of equity capital

Abstract

The transition from high- to lower-carbon production systems increasingly creates regulatory and market risks for high-emitting firms. We test to what extent equity market investors demand a premium to compensate for such risks and thus might raise firms' cost of equity capital (CoE). Using data for 1,897 firms spanning 50 countries over the years 2008-2016, we find a distinct and robust positive impact of carbon intensity (carbon emissions per unit of output) on CoE: On average, a standard deviation higher (sector-adjusted) carbon intensity is associated with a CoE premium of 6 (9) basis points or 1.7% (2.6%). This effect is primarily explained by systematic risk factors: high-emitting assets are significantly more sensitive to economy-wide fluctuations than low-emitting ones. The CoE impact of carbon intensity is more pronounced in high-emitting sectors, EU countries, and firms subject to carbon pricing regulation. Our results suggest that carbon emission reduction might serve as a valuable risk mitigation strategy.