The central question
If investors care about climate, do financial markets actually penalize high-emitting companies enough to change corporate behavior?
We have selected two recent working papers that provide different but converging perspectives:
- Do carbon emissions affect the cost of capital? Primary versus secondary corporate bond markets
Authors: Daniel Kim, Sebastien Pouget
From: University of Waterloo, Toulouse School of Economics
The authors take an empirical approach, documenting what actually happens in bond markets. They use real transaction data from US corporate bonds (2005-2022) - Asset returns as carbon taxes
Authors: Lautaro Chittaro, Monika Piazzesi, Marcelo Sena, Martin Schneider
From: Stanford University
The authors take a theoretical/quantitative approach, establishing what should happen in frictionless markets.
What Theory Predicts (Chittaro et al.)
- In frictionless markets, a carbon tax can be perfectly replicated by requiring higher returns from dirty firms.
- The required return premium increases linearly with emission intensity (emissions/enterprise value).
- A serious $100/ton carbon tax would require substantial return premia—up to 5% at the 99th percentile.
- Current empirical premia of 2-3% replicate only ~$10/ton taxes, which is far too modest.
What Actually Happens in Bond Markets (Kim & Pouget)
- Real-world bond market data confirms weak incentives.
- On secondary markets, a carbon premium exists: there is a 17 bps difference between green and brown firms.
- But on primary markets, where firms actually raise capital, the premium is only 2.4 bps.
- Market frictions, such as dealer risk aversion and limited competition, reduce the premium by 85%.
- Green firms lost $2.6 billion in potential savings in 2022 alone.
Why Markets Fall Short
From Kim & Pouget:
- Dealers facing uncertainty about future climate preferences demand higher risk premia, compressing the carbon premium passed to issuers.
- Limited dealer competition reduces pressure to offer green firms better terms.
From Chittaro et al.:
- Even small shares of climate-indifferent investors (2%) can halve emission reductions by buying dirty firms at the same returns as clean ones.
- The distribution of emissions is heavily right-skewed i.e. incentives fail precisely where they’re most needed (the dirtiest firms).
What Would Work
Structural fixes (Kim & Pouget):
- Improve risk-sharing mechanisms for primary market dealers.
- Increase competition in underwriting.
- Enable direct green investor participation in primary bond markets.
Investor strategy fixes (Chittaro et al.):
- Shift from negative screening to positive incentives: Rather than divesting from dirty firms, provide subsidies (accept lower returns) for clean firms in sectors with high substitution potential e.g., electricity.
- Even small amounts of green capital (2% of wealth) can achieve meaningful reductions of 12-25% of a $100 tax if targeted correctly.
- Focus on Scope 1 emissions only to avoid measurement complexity and double-counting.
A Research agenda and policy implications
- Measurement: Standardize on Scope 1 emissions for cost-of-capital purposes.
- Market design: Reduce primary market frictions through better dealer competition and green investor access.
- Investment products: Develop strategies that subsidize clean firms in substitutable sectors, not just divest from dirty ones.
- Realistic expectations: Even with optimal design, markets alone won’t replicate a $100 carbon tax unless the vast majority of investors have strong climate preferences.
From Chittaro et al.
