How can company valuations incorporate carbon emissions?
A seminal paper by Bolton and Kacperczyk (2021), Do Investors Care About Carbon Risk?, offers valuable guidance. The authors examine stock returns in relation to firms’ Scope 1, 2, and 3 emissions, with two notable findings.
1. Absolute emissions matter to equity investors
Higher levels of Scope 1, 2, and 3 emissions are associated with higher expected stock returns — a “carbon premium.” This suggests investors demand additional return to hold high-emission firms. Importantly, the premium relates to total emissions, not just emission intensity.
2. Emission changes are also priced in
Year-on-year increases in emissions also carry a premium. Markets appear to penalise companies that are expanding their carbon footprint, even if their absolute emissions remain moderate.
While global unity on climate action may have weakened since this paper’s publication, its core insights remain relevant. The number of companies committing to science-based decarbonisation targets (SBTi) is at a record high, showing continued commercial recognition of climate risk.
Valuation practitioners should take note. When estimating a firm’s cost of equity — particularly in harder-to-abate sectors — a company’s emissions profile provides valuable information:
- How does it compare to peers in the same sector?
- How has it evolved in recent years?
- What is the go-forward transition plan, and how credible is it?
These considerations can help estimate a “carbon premium,” layered on top of traditional risk factors within the cost of equity. The size of that premium may further depend on the investor base or scenario being analysed. The Bolton and Kacperczyk study finds that moving from an average emitter to a moderately high emitter (roughly the top third of firms) corresponds to about 0.15 percentage points higher stock returns per month, or 1.8% higher per year.
In short, carbon is no longer just an externality — it’s becoming a priced component of value.
Source: Patrick Bolton, Marcin Kacperczyk. “Do Investors Care About Carbon Risk?” Journal of Financial Economics, Volume 142, Issue 2, May 2021, Pages 517–549.