Is Carbon Risk Priced in the Cross-Section of Corporate Bond Returns?

Tinghua Duan, Frank Weikai Li, Quan Wen

2023 | Academic | Carbon, Climate, Fixed Income, Risk & Performance

This paper examines the pricing of a firm's carbon risk in the corporate bond market. Contrary to the 'carbon risk premium' hypothesis, bonds of more carbon-intensive firms earn significantly lower returns. This effect cannot be explained by a comprehensive list of bond characteristics and exposure to known risk factors. Investigating sources of the low carbon alpha, we find the underperformance of bonds issued by carbon-intensive firms cannot be fully explained by divestment from institutional investors. Instead, our evidence is most consistent with investor underreaction to the predictability of carbon intensity for firm cash-flow news, creditworthiness, and environmental incidents.