Capital market response to emission rights returns: Evidence from the European power sector

Prior studies on the distributional effects of the European Union's Emission Trading Scheme (EU ETS) have so fir only relied on supply and demand data. Empirical evidence from capital markets has been missing. We address this gap and measure the ETS's economic consequences, using the expectations of investors towards the regulatory impact on firm value. Employing a multifactor model, we show that returns on common stock of the largest affected industry, power generation, are positively correlated with rising prices for emission rights. This implies that the market predicts that firms are not only able to pass on their share of the regulatory burden to customers but even achieve windfall profits by overcompensating for the costs. (C) 2009 Elsevier B.V. All rights reserved.