The Pricing of Carbon Transition Risk on European Union Sovereign Bond Yields

Abstract

This research investigates whether climate transition risk is priced into the sovereign bond yields of European countries, utilizing carbon dioxide emissions per capita as a proxy for transition risk. Seven additional variables that potentially may impact government bonds are incorporated into the model. This study employs a fixed effects panel regression approach using yearly data for 21 European Union countries from 2006 to 2021. The analysis is conducted for the entire period as well as two sub-periods, allowing the examination before and after the implementation of the Paris Agreement 2015. The findings indicate that CO2 emissions per capita are not priced into the yields. Furthermore, the dataset presents highly significant time effects. Therefore, it can be implied that carbon risk is undervalued in financial markets, which entails financial concerns for carbon-intensive economies and investors. Thus, sovereign bonds from these countries should be considered riskier and with the possibility of experiencing an abrupt fall in their market value in the future. To mitigate the potential negative impact, investors should diversify their portfolios and invest in bonds from sustainable-driven governments.