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The Pollution Premium

Last Updated on 10 February, 2024 by Rejaul Karim

The Pollution Premium” by Po-Hsuan Hsu, Kai Li, and Chi-Yang Tsou delves into the complex realm of asset pricing implications in the context of industrial pollution. This exhaustive study investigates the long-short portfolio of firms with high as opposed to low toxic emission intensity within specific industries.

Strikingly, the findings reveal an average annual return of 4.42%, persisting as a significant phenomenon even after thorough risk factor control. Elevated levels of toxic emissions thus appear to yield a distinctive pollution premium, resisting plausible explanations such as existing systematic risk factors, investors’ preferences, market sentiment, political affiliations, and corporate governance.

The paper introduces a novel and intricately modeled systematic risk factor specifically linked to environmental policy uncertainty, providing an innovative approach to measure regime shift risk through the growth of environmental litigation penalties.

Notably, this approach effectively encapsulates the pricing dynamics of emission portfolios’ returns, elucidating the nuanced interplay between environmental regulations and the cross-section of stock returns.

Abstract Of Paper

This paper studies the asset pricing implications of industrial pollution. A long-short portfolio constructed from firms with high versus low toxic emission intensity within a given industry generates an average return of 4.42% per annum, which remains significant after controlling for risk factors. This pollution premium cannot be explained by several explanations, including existing systematic risks, investors’ preference, market sentiment, political connections, and corporate governance. We propose and model a new systematic risk related to environmental policy uncertainty. We use the growth of environmental litigation penalties to measure regime change risk, and find that it helps price the cross-section of emission portfolios’ returns.

Original paper – Download PDF

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Author

Po-Hsuan Hsu
National Tsing Hua University – Department of Quantitative Finance; National University of Singapore (NUS) – Asian Bureau of Finance and Economic Research (ABFER)

Kai Li
Peking University HSBC Business School

Chi-Yang Tsou
The University of Manchester – Alliance Manchester Business School

Conclusion

In conclusion, the comprehensive analysis by Hsu, Li, and Tsou offers compelling insights into the intricate asset pricing implications of industrial pollution. Their exploration of the long-short portfolio reveals a noteworthy average annual return of 4.42%, a significant phenomenon that persists even after meticulous control for risk factors.

Notably, this pollution premium defies conventional explanations, proving resilient against systematic risks, investors’ preferences, market sentiment, political affiliations, and corporate governance. The paper introduces a groundbreaking model for a new systematic risk factor connected to environmental policy uncertainty, measuring regime shift risk through the growth of environmental litigation penalties.

This innovative approach effectively elucidates the pricing dynamics of emission portfolios’ returns, denoting the nuanced interplay between environmental regulations and the cross-section of stock returns.

In sum, this research provides a paradigm-shifting perspective on the complex relationship between industrial pollution and asset pricing, paving the way for a deeper understanding of its far-reaching implications in financial markets.

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FAQ

What is the main focus of the research on “The Pollution Premium”?

The main focus of the research is to explore the asset pricing implications of industrial pollution. The study specifically investigates the long-short portfolio of firms with high toxic emission intensity compared to those with low toxic emission intensity within specific industries.

What are the key findings regarding the pollution premium?

The key findings reveal that the long-short portfolio constructed based on toxic emission intensity generates a significant average annual return of 4.42%. Importantly, this pollution premium persists even after meticulous control for various risk factors. The study indicates that elevated levels of toxic emissions seem to result in a distinctive pollution premium in the cross-section of stock returns.

What are the implications of the research in the broader context of asset pricing and environmental considerations?

The research has broader implications in the field of asset pricing, particularly in the context of environmental considerations. By uncovering the pollution premium and introducing a novel systematic risk factor related to environmental policy uncertainty, the study contributes to understanding how environmental factors can impact the cross-section of stock returns. This has implications for investors, policymakers, and researchers interested in integrating environmental considerations into asset pricing models and financial decision-making.

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