Academic

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.

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.