This paper provides a theoretical framework showing that the EU carbon border adjustment mechanism (CBAM) creates incentives for EU trading partners to adopt domestic carbon pricing. To test this prediction, we collect information on the evolution of carbon pricing mechanisms and construct a measure of CBAM-exposure based on trade data across 163 countries. We find that the introduction of the carbon border measure increases adoption rates of carbon pricing policies in countries with greater trade exposure. A one-percentage-point increase in CBAM-exposure raises the probability of adopting carbon pricing by 1.6 percentage points, a 17% increase on the pre-CBAM adoption rate. This effect concentrates among higher income countries consistent with lower income countries facing capacity constraints to implement similar mechanisms.

We study the effects of carbon price uncertainty on firms’ decisions to decarbonize their operations. We first use information on the pricing of options on emission allowances in the European Emissions Trading System to create the Carbon VIX, a market-based high-frequency measure of carbon price uncertainty. Carbon price uncertainty is high, varies substantially over time, and experiences persistent shocks around major climate policy events. To explore the effects of carbon price uncertainty on expected aggregate decarbonization investments, we analyze its effect on the stock returns of firms that help other businesses decarbonize. To identify these “carbon solution providers”, we extract common types of decarbonization investments from a large survey of firms, and then identify companies that offer the associated goods and services. We find that the stock returns of these carbon solution providers vary positively with carbon prices, but negatively with carbon price uncertainty. The effect of increases in carbon price uncertainty on our proxy for expected decarbonization investments is economically large and of similar magnitude as the effect of declines in carbon prices. These findings support predictions from real options theory that firms may delay investments in decarbonization when faced with uncertainty about the future costs of emissions.

Based on administrative data, I construct a novel dataset of firm-level holdings of emission permits in the EU Emission Trading System. Emission permits take a sizable share on firms' balance sheets and a majority of firms hold large quantities of emission permits in excess of their emission levels. I find evidence that holders of excess permits retain permit holdings to hedge future shocks to carbon prices. Firms with excess holdings (1) trade less, (2) sell more permits when carbon price uncertainty is low, and (3) show smaller reductions in future emissions. These results are consistent with models of firms' permit trading and decarbonization behavior under risk aversion and uncertainty and provide empirical evidence that carbon price uncertainty leads to limited trading participation and excess cost of decarbonization.

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.