Carbon Premium & Policy Uncertainty: An Analysis of Correlation Between Carbon Exposure and Stock Returns, and the Impact of Presidential Elections on Carbon Risk.

Abstract: Earth's climate is changing, but the timing and extent of policy responses remain uncertain. This paper aims to test the correlation between firms' carbon emissions and stock returns. The analysis is two-leveled; a general test throughout the period 2012 to 2022, and two separate tests surrounding the last two American presidential elections. The purpose of the latter analysis is to understand if investors are accounting for policy change probabilities as part of their risk compensation. The paper draws inspiration from a forthcoming Journal of Finance paper, The Pollution Premium, authored by Hsu et al. (2022). Hsu et al. suggest a micro-founded general equilibrium model, where the possibility of stricter policies induces a negative price of risk for high-polluting firms. We test this relationship and utilise the last two presidential elections as shocks to the probabilities of stricter policies for carbon emissions on the firm level. The data used in the tests are monthly stock returns for New York Stock Exchange listed firms, as well as Refinitive Eikon for emission and firm-level financial data. The result of this paper suggests a significant negative correlation between carbon exposure and stock returns, particularly when measured in emission intensity. The result also supports previous findings of the importance of business sectors. The 2016 Trump election win also has a significant, negative impact on the correlation between firms' emission exposure and their stocks' returns while controlling for sectors. In contrast, the effect of the Biden election is more ambiguous. This result suggests that presidential elections may impact how investors account for carbon risk, but that the impact is likely contingent on factors surrounding such elections.