The Impact of Low-Carbon Policy on Stock Returns

This paper assesses the impact of low-carbon policy on stock returns by means of an environmental extension of Fama and French's (2015) five factor model. This paper makes four major contributions. Firstly, for the first time a factor, GMC (green minus carbon), meant to provide the premium which results from not paying a carbon price is constructed. The GMC factor is obtained by means of a sample of 182 firms from 19 European countries operating in 35 sectors: from January 2008 to December 2018 the value-weight returns of 91 firms regulated by the 2003/87/CE directive are subtracted from the value-weight returns of 91 firms exempted by the 2003/87/CE directive upon which the EU-ETS is based. Secondly, we provide evidence that the addition of the GMC factor improves the performance of the 5 factor model in Europe in the 2008-2018 time span. Thirdly, results show that there is a high green premium rather than a carbon premium as it was asserted by parts of the literature, and that this green premium is highly statistically significant. Fourthly, after performing a carbon stress test, we show the effects of EU-ETS average price shocks on both carbon and green firms for each market cap tranche