We provide evidence that firms with higher carbon exposure earn lower future returns in asset pricing context in U.S. stock markets for a 41-year period from January 1976 to December 2016. The quintile hedging strategy buying the lowest CO2 emission beta portfolio and selling the highest emission beta portfolio earns 3.6-5.3% average annual returns (4.3-6.2% on decile). The negative relation between carbon exposure and future returns is consistent with the view that CO2 emissions are indicative of perceived deterioration of investment opportunities by investors. Our evidence is also consistent with the view that asset prices have an optimistic bias because investors with low value expectations stay on the sideline without trading. Notably, our result is not consistent with a risk premium view that carbon exposure proxies for market risk nor with a view that no trading profits are possible on the basis of publicly available information on CO2 emissions. Our preliminary additional tests suggest, however, that our main results are more supportive of the investment opportunities explanation than the Miller’s optimistic pricing view.

JEL codes: G12, Q54, G11, G32

Keywords: Climate finance, climate change, carbon emission exposure, asset pricing, risk management