Abstract
This paper provides an empirical investigation of the effect of the European Union's Emissions Trading Scheme on German stock returns. We find that, during the first few years of the scheme, firms that received free emission allowances on average significantly outperformed firms that did not. This suggests the presence of a large and statistically significant carbon premium, which is mainly explained by the higher cash flows due to the free allocation of emission allowances. A risk factor can also explain part of the cross-sectional variation of stock returns as firms with high emissions have higher exposure to risk and exhibit higher expected returns.
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