Abstract

The paper investigates the role of asset prices in addressing climate change, focusing on how climate risks affect financial markets and drive technological progress. Existing research suggests that high-polluting firms face a significant “pollution premium,” meaning they incur a higher cost of capital. This premium can disrupt financial stability when climate shocks suddenly increase capital costs, potentially stalling much-needed investments in green technologies. However, the underlying causes of this premium remain debated.

While prior studies attribute the pollution premium to regulatory changes or shifting investor preferences toward socially responsible assets, the paper works in a production-side framework. We base on a model where a firm’s cost of capital depends on its expected productivity growth, which is uncertain due to climate change. Firms can hedge this uncertainty by investing in R&D for abatement technologies, thereby increasing their resilience to climate shocks.

The study empirically tests this framework using a global dataset of R&D investment in green technologies. The key insight is that the expected return on R&D is linked to the expected abatement cost, proxied by the price of European Union carbon allowances. A higher allowance price signals a higher marginal cost of pollution, encouraging firms to invest in cleaner technologies.

To estimate the model, the paper employs a Generalized Method of Moments (GMM) approach, using an efficient moment selection procedure to mitigate identification issues.

The findings have important policy implications, particularly for regions like Australia, which is implementing a cap-and-trade system similar to the EU’s. By linking asset pricing to pollution costs, the research highlights how financial markets can drive climate innovation, ultimately influencing the effectiveness of environmental regulations.