Carbon Intensity and the Cost of Equity Capital.

• Author: Trinks, Arjan

1. INTRODUCTION

   The transition from high- to lower-carbon production systems creates substantial uncertainties in firms' regulatory and business environments. Especially the extent to which carbon regulation and market developments will make carbon-intensive production more costly represents a significant risk to future cash flows (Ansar, Caldecott, and Tilbury, 2013). In financial markets, this risk has been labeled 'carbon risk' and has become a growing concern for investors (Dyck et al., 2019; Kruger, Sautner, and Starks, 2020). (1) Investors increasingly show an interest in reducing exposure to high-emitting firms through divestment (Trinks et al., 2018), carbon-tilting strategies (Andersson, Bolton, and Samama, 2016; Kruger, Sautner, and Starks, 2020; Amir and Serafeim, 2018), or investment in green mutual funds (Ibikunle and Steffen, 2017). (2) The banking sector develops policies to reduce the financing of high-emitting businesses (RAN et al., 2019), and credit rating agencies incorporate climate-related financial risks in their assessments (Mathiesen, 2018). In the same vein, financial market regulators explore how excessive capital allocation to high-carbon assets might undermine financial stability, and whether additional policy interventions might be required to constrain access to capital for such assets (ESRB, 2016; PDC, 2017; TCFD, 2017).

   This paper investigates to what extent financial market investors demand a premium for holding assets of high-emitting firms, thereby raising those firms' cost of equity capital (CoE). We exploit two main sources of carbon emission data for an international sample of 1,897 firms spanning 50 countries over the years 2008-2016. Using a combination of portfolio-level analyses and panel regression techniques, we show how firms' CoE is impacted by carbon intensity (carbon emissions per unit of output), which is a well-known measure of firm-level use of and reliance on carbon sources, and hence carbon risk (Hoffmann and Busch, 2008; Kruger, Sautner, and Starks, 2020).

   Our analysis makes three contributions. Firstly, it adds to the understanding of the impact of firms' carbon emissions on financial risk and asset prices. Financial market investments are crucial to facilitate and stimulate low-carbon activity (IPCC, 2018; UNFCCC, 2015). However, much is still unknown about the extent to which this role is actually being performed and which policy interventions might be required and fruitful to drive low-carbon investment. Thus far, attention has been paid to the theoretical effects of public emission reduction on economy-wide risks and social discount rates (Dietz, Gollier, and Kessler, 2018). Yet, private investment is more directly driven by the discount rate applied to the cash flows of individual firms and projects. This is the rate of return demanded by investors to compensate for investment risk, or--from the perspective of firms--the cost of capital (Albuquerque, Koskinen, and Zhang, 2019; Elton et al., 2014; Sharfman and Fernando, 2008). Our analysis of the effects of carbon intensity is useful to industry practitioners and other areas of academic research, which increasingly rely on this measure. (3)

   Secondly, this paper contributes to the empirical literature on direct risk and return effects of corporate sustainability and environmental performance more specifically (Chava, 2014; El Ghoul et al., 2011; Ng and Rezaee, 2015; Sharfman and Fernando, 2008). To date, no consensus exists about the value relevance of firms' environmental performance (Horvathova, 2010). It is particularly unclear which kinds of such performance are relevant financially and why (Albuquerque, Koskinen, and Zhang, 2019; Benabou and Tirole, 2010). To a large extent, this is due to the almost exclusive focus on aggregate and indirect ratings of environmental performance in the extant finance literature and practice (cf. Liang and Renneboog, 2017; Ng and Rezaee, 2015; van Duuren, Plantinga, and Scholtens, 2016). Despite the widespread use of such ratings, strong concerns exist about their validity and measurement objective (Chatterji, Levine, and Toffel, 2009; Chatterji et al., 2016; Dorfleitner, Halbritter, and Nguyen, 2015; Semenova and Hassel, 2015). Most ratings tend to focus on firm policy and disclosure levels, which may merely reflect symbolic activities rather than actual impacts and associated risks (Chatterji et al., 2016; Gonenc and Scholtens, 2017). (4) Besides, while covering a broad scope of potentially relevant issues, what is being measured is often ambiguous (ibid.). Environmental performance ratings are also not verified, validated, or replicable based on publicly available information. (5) As a result, robust evidence on effect drivers is lacking, and aggregation bias poses a serious concern. This perpetuates the ambiguity and lack of consensus about the value relevance of firms' environmental performance. Our analysis addresses the issue by focusing on carbon intensity as a single, coherent measure of environmental impact.

   Lastly, we combine portfolio-level analyses with robust panel regression techniques to disentangle the pricing implications of carbon intensity. Building on the finance literature on sustainability, we argue that firms that emit less carbon could benefit from lower CoE through reduced regulatory and market risks (Albuquerque, Koskinen, and Zhang, 2019; Chava, 2014; Grey, 2018; Sharfman and Fernando, 2008) and a larger investor base (Fama and French, 2007; Heinkel, Kraus, and Zechner, 2001). Our analysis contributes to the literature by examining two mechanisms through which carbon intensity might command a risk premium going forward, specifically, systematic and non-systematic risk factors (Dam and Scholtens, 2015). The systematic risk of an asset reflects its sensitivity to economy-wide fluctuations. It is the level of risk in investment portfolios that remains when other, non-systematic risks are eliminated through diversification. As a result, mainstream finance theory holds that only systematic risk requires compensation and raises firms' CoE (Albuquerque, Koskinen, and Zhang, 2019; Elton et al., 2014; Sharfman and Fernando, 2008).

   Recent studies by Liesen et al. (2017) and Gorgen et al. (2020) have aimed to test whether firms' carbon emissions reflect risks other than the conventional systematic risk factors. For instance, Gorgen et al. (2020) construct a new risk factor that captures the return differential between groups of 'brown' and 'green' firms which are comparable in terms of their size. The factor did not carry a significant risk premium over the period 2010-2017, even though it added explanatory power to conventional systematic risk factors. Our analysis adds the possibility that carbon intensity commands a risk premium through the mechanism put forward by mainstream finance theory, namely by affecting systematic risk. By examining this mechanism, next to the potential role of non-systematic risk, our empirical findings are firmly embedded in mainstream theory and comparable to related studies (Dietz, Gollier, and Kessler, 2018; Fisher-Vanden and Thorburn, 2011; Monasterolo and de Angelis, 2020; Ziegler, Busch, and Hoffmann, 2011). Our findings will also be useful for practitioners, which typically use systematic risk to estimate the CoE (Levi and Welch, 2017).

   This paper proceeds as follows. Section 2 develops the main hypotheses. Sections 3 and 4 outline the methods and data. Results are presented in Section 5. Section 6 concludes.

2. CARBON EMISSIONS AND REQUIRED RETURNS: THEORY AND HYPOTHESES

   A hotly debated issue in the financial economics literature and practice is whether capital markets privately reward firms' sustainability (Ferrell, Liang, and Renneboog, 2016; Fisher-Vanden and Thorburn, 2011). Mainstream finance theory holds that all activities not targeted at creating value for shareholders ultimately destroy firm value (Jensen and Meckling, 1976; Preston and O'Bannon, 1997). But recent literature suggests that firms' sustainability is positively related to their financial health (Ferrell, Liang, and Renneboog, 2016; Lins, Servaes, and Tamayo, 2017). A key underlying mechanism is that firms' sustainability has a cash flow-preserving or insurance-like effect. By taking actions that address concerns of a broader set of stakeholders, firms reduce the exposure to and impact of regulations, reputational damages, and litigation events (ibid.). As a result, sustainability may be rewarded in capital markets through a lower discount rate that investors apply to firms' cash flows, i.e. through a reduction of the cost of capital.

   We empirically investigate this risk mitigation hypothesis for firm-level carbon emissions. Adopting an investor perspective, we test whether high-carbon assets are being penalized in capital markets through higher required rates of return on equity capital (CoE) as a compensation for their associated risk profiles. Finance theory identifies two mechanisms through which carbon intensity might affect CoE, these are screening activity and systematic risk.

   2.1 Hypothesis 1: screening

   Investors may not only maximize utility over means and variances of returns, but also over non-financial issues such as firms' contribution to climate change (Fama and French, 2007; Heinkel, Kraus, and Zechner, 2001; Dam and Scholtens, 2015). That is, investors concerned about climate change would require lower (higher) risk-adjusted returns if such returns are earned on less (more) environmentally harmful production activities. If high-carbon assets are screened out by a sufficiently large share of the market, this will lead investors in them to require additional returns for the increased risk they bear due to impaired diversification (ibid.). Hence, the screening mechanism predicts a return premium, or higher CoE, for high-carbon assets compared to low-carbon assets, which is not fully explained by common risk...