The Pollution Premium

By | September 22, 2022

While industrial pollution is widespread in the modern world and affects everyone’s life, whether it influences the returns on stock investors is an important yet underexplored issue. In our recent paper, we attempt to examine why and how industrial pollution affects expected stock returns using both modeling and empirical approaches. Polluting firms may save costs by not investing in emission abatement and environmental recovery in the short run. However, the emissions released by those firms are monitored by the public, media, and government in the long run. Thus, while polluting firms gain higher earnings now, they could be subject to activists’ protests, litigation risk, poor reputations, and penalties imposed by government agencies in the future. Given the substantial role of industrial pollution in short- and long-term earnings and cash flows, we would assume that firms of different levels of emissions should provide different returns to their investors.  

To study our proposition, we measure a firm’s “emission intensity” using its pollution data from the Toxic Release Inventory (TRI) database that is open to the public and maintained by the U.S. Environmental Protection Agency (EPA). Manufacturing firms above certain scale are required to disclose their emissions to the EPA and these data are organized in the TRI database. We find that firms emitting more (i.e., firms with higher emission intensity) are indeed more profitable now; however, they are also associated with a higher frequency or probability of being involved in environment-related lawsuits in the future.  

To further understand the relevance for stock investors, we then assign firms to five portfolios based on their emission intensity. Such portfolio construction enables us to implement a long-short portfolio strategy that buys the most polluting stocks and sells short the least polluting stocks. This strategy provides an annual return of 4.42%. Our analyses suggest that an extensive list of explanations proposed in the literature cannot explain this pollution premium.  

To explain the puzzling stock returns of polluting firms, we then propose and model a new systematic risk based on environmental policy uncertainty following Pastor and Veronesi (2012, 2013). In this model, firms’ profits are subject to regime shifts with respect to the government’s environmental regulation. When the government is more lenient, polluting firms gain higher profits than clean firms by saving/cutting abatement costs; however, when the governments switches to a tighter environmental regulation regime, polluting firms are penalized and gain lower profits than clean firms.  In other words, high-emission firms’ profitability is more sensitive to government changes in environmental regulations. Thus, investors will discount the stock prices of polluting firms because they demand higher expected returns as premium on holding these polluting stocks as they are subject to environmental regulation risk.  

To further examine if our model fits the data, we find that the stock market perceived the 2016 presidential election outcome as good news for polluting firms and raise their stock prices. Moreover, we also examine polluting firms’ long-term profitability and find that these firms’ long-term profits decline more when there are more environment-related lawsuits filed. These empirical results suggest that our model explains real-world events reasonably well.   

Our paper is informative for the financial industry, manufacturing firms, and governments. First, our work offers a theoretical basis for the financial industry that promotes various investment strategies, indices, and funds related to climate change, corporate social responsibility (CSR), and environmental, social, and governance (ESG). Second, our model and empirical evidence highlight a new source of systematic risk for stock investors: a regime shift risk of emission regulation that impacts polluting firms. Such a risk ought to be considered in investors’ portfolio selection and construction procedures. 

In addition, our research points out that the uncertainty in environmental policies and regulations works as a new source of economic risk for corporate operations and supply chain coordination. Thus, the stability of environmental policies and regulations becomes an important issue to both corporate managers and policy makers.  


Po-Hsuan Hsu is a Professor and Yushan Fellow at the National Tsing Hua University College of Technology Management.  

Kai Li is a tenured Associate Professor of Finance at the Peking University HSBC Business School and Sargent Institute of Quantitative Economics and Finance.  

Chi-Yang Tsou is an Assistant Professor of Accounting and Finance at the University of Manchester Alliance Manchester Business School.  

This post is adapted from their paper, “The Pollution Premium” available on SSRN 

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