Asset Returns as Carbon Taxes

In frictionless financial markets, a carbon tax on energy users provides the same incentives as a replicating asset price schedule that depends on emissions. In particular, the replicating rate of return on a firm increases linearly in scope 1 emissions relative to enterprise value. We use this result to interpret pollution premia measured by recent empirical studies and conclude that markets currently provide only modest incentives. Replicating a serious carbon tax requires high returns in the right tail of the emission intensity distribution. With heterogeneous investors, such returns are not sustainable unless essentially everyone perceives large nonpecuniary costs from holding dirty capital. Substantial emission reductions can be achieved, however, when even a small share of investors perceive nonpecuniary benefits from owning clean electricity capital.