Carbon Risk in European Equity Returns

Abstract

Investors perceive climate change and the volatility of asset prices caused by the ongoing low carbon transition of the economy, so-called carbon risk, to have an impact on their portfolio performance. However, the extent of carbon risk's impact on asset prices is still largely unknown. This paper provides a comprehensive quantification of carbon risk in European equity prices and examines whether it constitutes a systematic risk factor. I construct a carbon risk factor to determine the unique share of return attributable to differences in carbon intensity. During the sample period less (more) carbon intensive firms offer higher (lower) returns, which leads to a significant positive return of the carbon risk factor. Moreover, the carbon factor is significantly related to the sample covariance matrix of returns and offers a carbon risk premium in the cross-section of returns. In combination with the enhanced explanatory power relative to standard asset pricing models, this indicates that carbon risk constitutes a systematic risk factor. Consequently, investors can estimate carbon risk exposures based on widely available stock returns and include stocks without explicit carbon emission information in their risk management and investment process.

Keywords: Carbon risk; carbon risk factor; factor model; asset pricing.