The Pricing of Climate Risk

Abstract

This study investigates whether corporate climate risk is priced by the capital markets. Using carbon dioxide emission rates of publicly traded U.S. electric companies, we find that climate risk is positively associated with cost of capital measures, more specifically the implied cost of equity and the cost of debt. Additionally, we find that equity and debt investors evaluate corporate climate risk differently. The results show that the cost of debt decreases with the level of capital intensity, suggesting that debt investors value the increase in efficiency resulting from current capital investments. The results also show that the cost of equity decreases and the cost of debt increases with the newness of assets in places. Newer equipment is likely to be operationally and environmentally more efficient. While the results concerning the cost of debt are puzzling, we consider that debt investors may account for other performance indicators. We conclude that equity and debt investors evaluate climate risk differently according to their different payoff functions.