Green Finance, Asset Pricing and Market Risk Premia: Where Do We Stand?

ABSTRACT: This paper investigates whether climate-related preferences and risks constitute a systematically priced factor in financial markets and whether the observed greenium provides evidence of such pricing across sovereign bonds, corporate bonds, and equity markets. The development of green finance has been an important financial breakthrough in the domain of sustainable finance. Green bonds and green equities constitute the two primary categories of environmentally oriented investment instruments that have gained significant traction in financial markets. They constitute a financial market response to the challenges and risks brought about by climate change and are an important driver in accelerating the transition of the planet toward a more sustainable economic development model and carbon neutrality. An important question, from the investors and issuers (including sovereign) standpoint, is the extent to which climate change risk is (systematically) priced in financial markets. Establishing the size of the implied green risk premium is relevant for all market participants (investors and issuers) and policymakers alike. We review the evidence of green risk premium (greenium) in asset markets across jurisdictions in developed and (some) emerging markets. All in all, the estimated greenium is more often than not statistically significant, albeit relatively small in its size. Based on evidence from (mostly) academic and institutional literature, we present key insights into how investors’ environmental concerns can drive green asset prices. We report that over time the greenium can widen from 0 up to nearly 20 basis points; its impact on asset prices is tangible, especially for long duration assets. This does indicate that the greenium exists, and it is relevant. Also, it suggests that (at least some) investors appear to be willing to “subsidise” green projects by paying a premium on holding green assets. Moreover, greenium can have a persistent, albeit time-varying, impact on asset prices. Green bonds issued by the public sector display a more consistent pattern in the estimated greenium level across different markets, possibly with a greater size for emerging market debt.