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On Bond Returns in a Time of Climate Change

The study of the financial repercussions of low-carbon policy has focused mainly on stocks, leaving bonds out of the picture. The objective of this paper is to assess the impact of low-carbon policy upon European bond returns. This is done by extending the Fama and French two factor model for bonds with an EU-ETS participation factor: GMC (Green minus Carbon). This paper makes four contributions. Firstly, it provides a statistically highly significant measure of the sensitivity of bond portfolio returns to the GMC factor. Secondly, it shows the presence of a green premium in the European bond market in between 2008 and 2018. Thirdly, evidence is found that the addition of an environmental factor improves the performance of the original model. Fourthly, the carbon stress test put forward is able to indicate the effects of a plausible but more severe average EU-ETS carbon price on bond returns.

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Keywords: Bond returns, Low-carbon transition risks, Green premium, EU-ETS, Asset pricing model

DOI: 10.5547/01956574.43.1.arav

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Published in Volume 43, Number 1 of the bi-monthly journal of the IAEE's Energy Economics Education Foundation.


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