We study the effects of carbon price uncertainty on firms’ decisions to decarbonize their operations. We first use information on option prices for emissions allowances in the European Emissions Trading system to create the Carbon VIX, a market-based high-frequency measure of carbon price uncertainty. We then construct a measure of expected aggregate decarbonization investments via stock returns of “carbon solution providers”. Consistent with real-option theory, we find a 10 percentage point increase in carbon price uncertainty has a similar negative impact on decarbonization activities as a EUR 11 decline in the carbon price.

Data available at: www.carbonvix.org

Using Euro area banks’ credit register data, information on borrowers’ greenhouse gas emissions and their countries' degree of climate policy action (CPA), we study whether banks price climate-related policy risk in their corporate loan portfolios. We find these risks are priced only when polluting borrowers face high levels of CPA. This effect is driven by loans originated after the adoption of the Paris Agreement and is more pronounced for long maturity loans. Benefiting from bank-level survey results, we show that this effect is larger in terms of scope and magnitude if loans are provided by green banks.

A draft is available upon request.

I construct a measure of cash flow duration at the firm level and link it to carbon emissions of the same firm. Firms that generate their cash flows in the near term emit more carbon, reflecting that short-term cash flows are relatively less exposed to regulatory climate risks. This relationship leads to high correlations of emission and duration premiums. Return differences are driven by emissions instead of duration and disappear after controlling for changes in investors' climate concerns. These changes, together with the novel link between duration and emissions, provide an intuitive empirical explanation for the recent underperformance of value.