Emissions trading and the cost of equity: Evidence from high-carbon firms in china

Background and Motivation

With climate change intensifying global demands for carbon reduction, market-based instruments like the Emissions Trading System (ETS) have become essential for countries seeking to balance economic growth with environmental responsibility. China, aiming for a low-carbon transition, launched ETS pilots in multiple regions beginning in 2013, eventually forming the world’s largest carbon market. However, the specific impact of these pilots on the cost of equity for high-carbon firms—and the roles played by regional economic development and firm characteristics—remains underexplored. China Finance Review International (CFRI) brings you a new article titled “Carbon emissions trading system and the cost of equity for high-carbon firms”, which systematically investigates this critical policy issue.

Methodology and Scope

This study exploits the staggered rollout of ETS pilots in China’s diverse regions, treating the policy as a quasi-natural experiment. Using a difference-in-differences (DiD) approach, the authors analyse a panel of A-share listed high-carbon firms across various industries (e.g., petrochemicals, power, aviation) from 2009 to 2018. The main variable of interest is the cost of equity, calculated via the CAPM model, while controls include firm and regional characteristics. Robustness checks employ alternative specifications, matching techniques, and subsample analyses to ensure the reliability of findings.

Key Findings and Contributions

• For Policymakers: Provide targeted support and incentives to non-state-owned and financially constrained high-carbon firms to help them adapt to ETS compliance. Design regionally tailored carbon trading policies that reflect local governance capacity and economic conditions, avoiding a one-size-fits-all approach. Encourage reforms that improve firms’ cash flow management, reduce distress risk, and stabilise stock prices to help high-carbon enterprises control their cost of equity.
• For Banks and Financial Institutions: Refine risk assessment models to account for increased equity financing risks among high-carbon firms after ETS implementation, especially for private and financially vulnerable enterprises. Develop innovative financing instruments, such as green bonds or blended finance products, to facilitate low-carbon transformation and ease the capital burden for affected firms.
• For Investors: Adjust equity portfolios by leveraging ETS-related risk assessments, focusing on firm ownership structure, financial constraints, and exposure to regional policy regimes to make more informed investment decisions.
• For Researchers: Extend the use of this study’s methodology and findings to further investigate the links between environmental regulation, financial markets, and corporate transformation, particularly in emerging markets undergoing low-carbon transitions.

Why It Matters

The study provides direct evidence that ETS, while advancing environmental goals, increases financing pressures for high-carbon firms, particularly those that are privately owned or financially constrained. This dynamic could hinder their green transition and overall competitiveness. For China—and other nations using emissions trading as a policy tool—the findings highlight the importance of tailoring regulatory and financial support to firm- and region-specific contexts to ensure that climate policy is both environmentally and economically sustainable.

Practical Applications

• Raise equity financing costs for high-carbon firms: China’s ETS leads to a significant increase—about 0.3 percentage points—in the cost of equity for high-carbon firms compared to those outside pilot regions.
• Intensify financial and operational risks: ETS compliance forces high-carbon firms to spend more on carbon quotas and emission reduction, resulting in greater operational uncertainty, heightened financial distress, and increased volatility in stock returns. This drives investors to demand higher risk premiums.
• Highlight the vulnerability and resilience across firm types: Non-state-owned and financially constrained enterprises experience more pronounced cost pressures, while firms with strong institutional or state ownership manage increased financing costs better due to superior resource access and support.
• Amplify policy impact through local institutional quality: The effect of ETS is stronger in regions with robust governance, advanced urbanisation, and larger market size, emphasising the importance of local institutional context in shaping policy outcomes.
• Broaden understanding of environmental regulation’s financial influence: The research reveals how market-based environmental policy transforms corporate financing conditions and risk in China’s transition to a low-carbon economy.

Discover high-quality academic insights in finance from this article published in China Finance Review International. Click the DOI below to read the full-text original! Open access for a limited time!