The European Central Bank published Working Paper No 3030, “Green and brown returns in a production economy”, examining whether investing in low-emission firms has delivered higher returns and proposing a mechanism that ties this outperformance to carbon pricing under the European Union’s Emission Trading System (EU ETS). The paper, produced within the ESCB’s ChaMP research network, argues that a well-functioning carbon market can generate a green equity premium by changing the risk properties of high-emission firms’ cash flows. Using value-weighted decile portfolios of European firms sorted by Scope 1 emissions, the authors find that from 2013 to 2022 the green portfolio earned average four-quarter returns of 5.52% versus 3.52% for the brown portfolio, implying a green-minus-brown premium of 2.01%. The paper documents procyclical movements in EU ETS allowance prices, with four-quarter allowance-price growth positively correlated with euro area GDP growth (0.27) and with the green-minus-brown portfolio (0.07), strengthening to 0.18 when excluding the period affected by the Ukraine-related energy shock. In a two-sector production economy where brown firms must purchase emissions permits, a procyclical carbon price raises brown firms’ costs in booms and lowers them in downturns, smoothing brown dividends and reducing the risk premium investors require to hold brown equities. In the calibrated model, an average carbon price of around EUR 12 per tonne broadly reproduces the observed return gap, while eliminating carbon pricing removes the asymmetry. Preference-based explanations are also tested, with the paper finding that eliminating the green premium via stigma would require roughly a 26% reduction in the brown portfolio’s market value, and generating a 1% carbon premium would require a roughly 38% reduction; introducing a preference tilt toward green bonds can increase the green premium and, alongside leverage data showing higher leverage for brown firms, complicates explanations based on preferences alone.
European Central Bank 2025-02-18
European Central Bank working paper links EU ETS carbon pricing to a 2% green equity premium in euro area stocks
The European Central Bank's Working Paper No 3030 explores the outperformance of low-emission firms, linking it to carbon pricing under the EU Emission Trading System. The study finds a green-minus-brown premium of 2.01% from 2013 to 2022, with procyclical carbon prices affecting brown firms' costs and risk premiums. The paper also examines preference-based explanations, noting that stigma and preference tilts could influence the green premium.