The Pollution Premium

This paper studies the implications of environmental pollution on the cross-section of stock returns. A long-short portfolio constructed from firms with high versus low toxic emission intensity within industry generates an average return of 5.52% per annum. To explain this pollution premium, we develop a general equilibrium asset pricing model in which firms’ cash flows face the uncertainty of policy regime shifts with respect to the environmental regulations. High emission (“dirty”) firms are more exposed to policy regime shift risks, and are therefore expected to earn higher average returns than those of low emission (“clean”) firms.