The Pricing of Climate Risk

Journal of Financial and Economic Practice, Vol12(2), Spring 2012, 115-131.

25 Pages Posted: 16 Mar 2012 Last revised: 7 Sep 2012

See all articles by Linda H. Chen

Linda H. Chen

University of Idaho

Lucia Silva Gao

University of Massachusetts Boston

Date Written: October 7, 2011

Abstract

This study investigates whether corporate climate risk is priced by the capital markets. Using carbon dioxide emission rates of publicly traded U.S. electric companies, we find that climate risk is positively associated with cost of capital measures, more specifically the implied cost of equity and the cost of debt. Additionally, we find that equity and debt investors evaluate corporate climate risk differently. The results show that the cost of debt decreases with the level of capital intensity, suggesting that debt investors value the increase in efficiency resulting from current capital investments. The results also show that the cost of equity decreases and the cost of debt increases with the newness of assets in places. Newer equipment is likely to be operationally and environmentally more efficient. While the results concerning the cost of debt are puzzling, we consider that debt investors may account for other performance indicators. We conclude that equity and debt investors evaluate climate risk differently according to their different payoff functions.

Keywords: environmental risk, cost of equity, cost of debt

JEL Classification: G12, M14, M41, Q48

Suggested Citation

Chen, Linda H. and Silva Gao, Lucia, The Pricing of Climate Risk (October 7, 2011). Journal of Financial and Economic Practice, Vol12(2), Spring 2012, 115-131., Available at SSRN: https://ssrn.com/abstract=1940727 or http://dx.doi.org/10.2139/ssrn.1940727

Linda H. Chen (Contact Author)

University of Idaho ( email )

Department of Accounting
College of Business and Economics
Moscow, ID 83944-3174
United States

Lucia Silva Gao

University of Massachusetts Boston ( email )

100 Morrissey Blvd
Boston, MA 02125
United States

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