The E-axes Forum on Climate Change, Macroeconomics, and Finance

Funding the Fittest?

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Yasmine Van der Straten

University of Amsterdam

To reach net-zero emissions by 2050, the global productive system must decarbonize. Yet, current policies and actions are inadequate in addressing climate change, creating considerable uncertainty around the transition and leaving businesses exposed to climate transition risk. A recent literature studies whether investors price climate transition risk. As the transition progresses slowly, this question gains relevance since the price of capital acts as signal of risk, and hence guide efforts to mitigate climate risk. Forward-looking investors may thus play a key role in promoting the green transition, by redirecting capital towards green activities rather than brown ones.

Pricing Climate Transition Risk in the Corporate Bond Market

In our paper Boermans et al. (2024), we study whether corporate bond investors price climate transition risk. By combining confidential bond-level holdings data with global firm-level data on greenhouse gas emissions, we present evidence of a positive transition risk premium. Bond yield spreads increase in a company’s emission intensity, indicating that investors perceive these companies as more risky. Bond credit risk, green bond labels, and other factors fail to explain this transition risk premium, underscoring the crucial role of carbon emissions in determining the cost of capital. We take a forward-looking perspective by examining whether investors value companies’ green innovation efforts, using firm-level data on (green) patents. Our analysis reveals that investors reward carbon emission intensive companies that make an effort to become more green, as the risk premium is smaller for emission intensive firms that engage in green innovation. Additionally, our findings indicate that European investors – particularly European institutional investors – are more inclined to reward emission intensive companies that engages in green innovation. This aligns with the broader initiatives within the European Union aimed at promoting sustainable finance.

Pricing Climate Transition Risk in Stock – and Credit Markets

The literature studying the pricing of climate transition risk in financial markets is growing rapidly, with the majority of research focusing on stock markets. The seminal work of Bolton & Kacperczyk (2021) presents evidence of a positive carbon premium in the cross-section of U.S. stock returns. Stocks of firms with higher CO2 emissions thus earn higher returns, indicating that investors already demand compensation for their exposure to climate transition risk. Hsu et al. (2023) provide additional evidence, showing that a portfolio that longs in stocks of high-pollution firms and shorts in low-pollution stocks generates positive annual returns. Moreover, the climate risk premium is observed in global stock markets (Bolton & Kacperczyk, 2023). These findings beg the question why sustainable investment is soaring. Pástor et al. (2021) shed light on this by demonstrating that an unexpected increase in climate not only shifts consumer tastes, which increases the cash flows of green firms, but also influences investors’ preferences, which reduces the discount factors. Then, while green assets hedge climate risk (implying that these assets earn lower returns compared to brown assets), they outperform when there is a positive shock to climate concerns. This prediction is empirically validated by Pástor et al. (2022) and Ardia et al. (2023). Altavilla et al. (2023) focus on credit market and reveal that euro area banks also price climate risk. The authors show that credit spreads are higher for firms with higher current emissions, while the premium is lower for firms that disclose emissions reduction targets. This latter observation aligns with our finding that the climate risk premium is lower for emission intensive firms that engage in green innovation. Altavilla et al. (2023) further show that the pricing effects are stronger for banks that publicly commit to environmentally responsible lending practices (see also Kacperczyk & Peydro, 2022), and that monetary policy affects the climate risk premium. Specifically, an unexpected increase in the ECB’s policy rate induces banks to tightening lending standards more for higher emissions firms, but less for those committed to reduce emissions.

Does Innovation Lead to Emission Reduction?

Investors reward carbon-intensive companies that engage in green innovation (Boermans et al., 2024), but does green innovation improve corporate environmental performance? Bolton et al. (2023) assess the effects of green and brown innovation worldwide on reducing carbon emissions, showing that green innovation does not predict future reductions in carbon emissions. The authors provide an explanation for this by demonstrating that there is path-dependency in innovation. Specifically, green innovation is undertaken by firms that are already green, and brown firms predominantly innovate in brown technologies. While Cohen et al. (2024) and Leippold & Yu (2023) provide a contrasting perspective, our findings align with those of  Bolton et al. (2023), suggesting that there remains ambiguity regarding the effectiveness of green innovation for improving environmental performance. This highlights the need for caution among investors when accommodating emission intensive companies by charging a lower climate risk premium once they innovate in the green space.

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