An empirical study on the impact of carbon emissions on the implied cost of capital

Abstract

This study explores the impact of sustainable investment initiatives, particularly those addressing carbon emissions, on the implied cost of capital for European companies. Aligned with the European Green Deal, the research draws inspiration from Palmer (2023) and Bolton & Kacperczyk (2021) to investigate the relationship between a company's carbon emissions and its implied cost of capital.

The literature review highlights the complexity of integrating carbon data into asset pricing models, emphasizing challenges and insights from prior studies. The research focuses on the carbon risk premium hypothesis using the methodology of Hou, Van Dijk & Zhang (2012) to calculate a firm’s implied cost of capital.

The data, sourced from LSEG and Compustat, covering STOXX600 stocks from 2004-2022, includes carbon emission data categorized into levels, growth, and intensity.

Our main findings suggest a strong positive relationship between the carbon emission levels and the implied cost of capital. The effect was further amplified by separating the industry averages, which suggests the importance of industry-wide patterns in the evaluation of climate-related risks. Additionally, firm residual emission intensity exhibits a strong negative relationship with the implied cost of capital, as the substantial number of firms consistently report lower than industry-average emission levels and expected return maintains at around 10%.

In summary, this research provides supportive insights into the relationship between carbon emissions and implied cost of capital, contributing to the understanding of sustainable investment impacts on financial markets.