The Double-Edged Sword of Firm’s Net Zero Commitment on the Carbon Risk Premium

This paper received an Honorable Mention from the 2024 E-Axes Forum Research Committee

The carbon risk premium represents the excess return that equity investors demand to compensate for their exposure to a company’s carbon risk. In response to this risk, a growing number of firms have declared a net zero commitment (NZC) to signal their intention to address carbon risk. In “The Double-Edged Sword of Firm’s Net Zero Commitment on the Carbon Risk Premium,” Keith Jin Deng Chan and Wilson Tsz Shing Wan demonstrate that a company’s NZC can increase or decrease the carbon risk premium associated with its equity, depending on the latter’s transition readiness. They also show that institutional investors shape the premium by divesting from high-emitting firms that have declared NZC.

Net zero commitment

The authors begin by demonstrating the presence of a carbon risk premium: a 1% increase in the GHG intensity of a firm is associated with a 1.7% increase in its annualised stock returns. They subsequently investigate how the carbon risk premium changes after a firm declares NZC, revealing that the effect is contingent on the firm’s transition readiness. Notably, a firm’s carbon risk premium increases after NZC if it exhibits a low transition readiness but decreases otherwise.

Transition readiness as a key factor

Based on the theoretical foundation laid in Chan, Cheung & Shen (2024), the authors characterize a firm’s transition readiness by three components: (i) transition capacity, measuring the cost-effectiveness of its available means to abate emissions; (ii) transition urgency, measuring the external pressure it faces to abate emissions; and (iii) discount rate, measuring the decision horizon of its investors.

The paper first theoretically studies how the enterprise value of a firm is affected by its transition ambition as signalled by its NZC declaration, and then empirically examines the impact of NZC on the carbon risk premium using a sample of 1,177 firms that had declared NZC by the end of 2022. The empirical findings corroborate the theoretical propositions, suggesting two distinct scenarios:

1. For firms with low transition readiness, the future benefits of addressing carbon risk are negligible relative to the abatement cost and are insufficiently valued by their investors given the latter’s short-termism. Consequently, the higher transition ambition of these firms communicated by their NZC is perceived negatively, as evidenced by an increase in their carbon risk premium.
2. For firms with high transition readiness, emissions abatement can be achieved in a cost-effective manner, duly addressing the high carbon risk that concerns their investors given the latter’s long-termism. Thus, the higher transition ambition of these firms communicated by their NZC is perceived positively, as evidenced by a decrease in their carbon risk premium.

Fig 1 – Change in carbon risk premium following a firm’s NZC by transition readiness

Institutional investors as a key channel

The study also examines the role of institutional investors in determining the carbon risk premium. The estimation results show that institutional investors tend to divest from high-emitting firms, and even more so if the latter have declared NZC. The rise in the carbon risk premium following NZC declaration is most pronounced among firms with the highest concentration of institutional ownership.

Fig 2 – Change in carbon risk premium following a firm’s NZC by share of institutional ownership

 Note: Statistically significant results (p-values less than or equal to 5%) results are shown in solid colours, while insignificant results are shown in more transparent colours.

 Policy Implications

To support the low-carbon transition of their economies, governments should adopt a dual approach: encouraging companies to make NZC, while simultaneously devising policies to support their transition readiness. The latter comprise building transition capacity, raising transition urgency, and extending decision horizons.

1. Building transition capacity involves boosting the carbon and energy efficiency of the economy. Reducing the emissions intensity of the energy mix is vital. Apart from directly providing subsidies to support green R&D, governments could leverage private capital by promoting the development of the green finance market to facilitate the diffusion of low-carbon technologies.
2. Raising transition urgency involves substantiating the national commitment to net zero. The government could project the trajectory of carbon prices and their sector coverage, stipulate how the technical screening criteria in their green taxonomies are to be tightened over time, and provide a clear roadmap of climate policies to affirm companies of the necessity to take climate actions.
3. Extending decision horizons involves aligning corporate governance with the long-term interests of companies. For instance, in April 2021, the Securities Commission Malaysia updated its Code of Corporate Governance to include a performance evaluations of the board and senior management in addressing the company’s material sustainability risks and opportunities.

By enhancing transition readiness at the institutional level, companies can benefit from a lower cost of equity by declaring NZC. At the system level, this can also enhance financial stability by preventing the buildup of carbon risk premium in the financial market, which could intensify co-movement of asset prices and abrupt price correction.