The Pollution Premium

Abstract

This paper studies the asset pricing implications of industrial pollution. A long-short portfolio constructed from firms with high versus low toxic emission intensity within a given industry generates an average return of 4.42% per annum, which remains significant after controlling for risk factors. This pollution premium cannot be explained by several explanations, including existing systematic risks, investors' preference, market sentiment, political connections, and corporate governance. We propose and model a new systematic risk related to environmental policy uncertainty. We use the growth of environmental litigation penalties to measure regime change risk, and find that it helps price the cross-section of emission portfolios' returns.

Keywords: Toxic emissions, regime shift risk, uncertainty, environmental regulation, cross-section of stock returns

JEL Classification: E2, E3, E4, G1, Q5