The Carbon Risk Premium

Abstract

This article provides an overview of compliance carbon markets that trade carbon emission allowances and analyzes the properties of carbon as an investable asset class. The authors discuss how local supply and demand factors determine allowance prices, focusing on abatement costs and policy adjustments. They then construct a novel total-return time series for four liquid carbon markets and develop an equally-weighted Carbon Composite. They found that individual carbon markets are uncorrelated to each other and commodities and asset classes unrelated to idiosyncratic market fundamentals. The Carbon Composite generated an annualized excess return of 26.63% and a Sharpe Ratio of 1.50 over 2013–2021, suggesting that carbon as an investable asset class could provide tangible diversification benefits to investors. The authors then explore the outlook for carbon as an asset class and identify theoretical and practical justifications for a prospective carbon risk premium.