Climate Policy Uncertainty and Green Bond Illiquidity: Challenges to Market Functions and Policy Perspective

Abstract

This thesis investigates the impact of climate policy uncertainty on the liquidity of the U.S. green bond market. Using the Climate Policy Uncertainty (CPU) Index developed by Gavriilidis (2021), I employ a fixed-effects panel regression model on a granular dataset of 5.6 million corporate bond transactions from 2019 to 2024 to assess how uncertainty surrounding climate policies influences bond-level liquidity. I measure liquidity through three distinct transaction-based proxies: the bid-ask spread, the Amihud measure, and the price interquartile range. The analysis controls for a comprehensive set of established determinants of bond liquidity, including bond-specific characteristics and macroeconomic factors. The results provide robust evidence that climate policy uncertainty is a significant and economically meaningful liquidity factor in the green bond market, though its impact is found to be time-varying. A one-median increase in the CPU Index is associated with a 6.64% increase in the bid-ask spread and 10.20% increase in the price interquartile range, indicating higher transaction costs for investors. This effect is distinct from and incremental to general economic policy uncertainty (EPU) and market volatility (VIX). Furthermore, a structural break analysis reveals that the relationship is dynamic and time-varying, with the impact of CPU on illiquidity being most pronounced in the period leading up to the COP26 summit before weakening as the economic narrative shifts. The findings demonstrate for investors that climate policy uncertainty is a tangible, though conditional, source of liquidity risk that requires active management, while highlighting for policymakers that creating a stable and predictable policy environment is crucial for lowering the cost of capital and fostering efficient green financial markets.