The double-edged sword of corporate net zero commitment on the carbon risk premium

To address climate change, an increasing number of firms have declared net zero commitments. In this article, we theoretically and empirically demonstrate that a firm's net zero commitment may present a double-edged sword on its cost of equity. By modelling a firm's optimal transition pathway, we theoretically elucidate the relationship between transition ambition, transition readiness, and enterprise value. By estimating the carbon risk premium for 1100 listed firms that had declared net zero commitments globally by 2022, we empirically show that such commitments can either increase or decrease a firm's carbon risk premium, depending on its transition readiness. Specifically, among firms with the same greenhouse gas emissions intensity, those with lower transition readiness may experience a higher cost of equity from declaring net zero commitments. These results align with our theoretical analysis and cannot be explained solely by values investors' green preferences nor the discounted transition credibility of high-emitting firms. Additionally, we show that institutional investors effectively channel carbon risk into the stock market by divesting from high-emitting firms that have declared net zero commitments. Our findings have important implications: firms whose transition readiness do not measure up to their transition ambition may paradoxically expose themselves to greater transition risk and, consequently, a higher cost of equity. To alleviate the accumulation of carbon risk premium in the stock market, policymakers should support the transition readiness of firms in their jurisdictions. This involves building transition capacity, raising transition urgency, and lowering investors' discount rates.