Does the carbon premium reflect risk or mispricing?

Here’s a note from Alex Edmans:

An influential stream of research finds that companies that emit more carbon have higher stock returns. This “carbon premium” has been interpreted as evidence that emitting companies suffer a higher cost of capital and thus markets are correctly pricing in carbon risk. However, the ESG literature typically interprets higher stock returns as outperformance due to mispricing.

In a new paper with Yigit Atilgan, Özgür Demirtaş, and Doruk Gunaydin, we study earnings surprises to disentangle these explanations. We find that emitting companies enjoy positive earnings surprises, and the four earnings announcements per year explain 30-50% of the annual carbon premium. Consistent with prior results, our findings only hold for levels of and changes in emissions, but not emissions intensities or disclosed emissions only. Our results suggest that, where it exists, the carbon premium arises from an unpriced externality – emitting companies are able to “get away with” contributing to global warming. Markets are not fully pricing in carbon risk, highlighting the need for government action.