Valuing the carbon exposure of European utilities. The role of fuel mix, permit allocation and replacement investments

This paper assesses the carbon exposure of European electric utilities covered by the EU Emissions Trading System (EU ETS). First, we rely on an asset pricing model to empirically determine the effect of carbon price risks on firm-specific cost of capital for a sample of 20 European utility stocks during the period 2005–2010. Second, we employ a discounted cash flow framework to simulate carbon-adjusted equity values for three selected utilities and their investment strategies from 2009 to 2020. We show that company-specific carbon risks are asymmetrically distributed to a few utility firms: While for the great majority of power producers carbon price movements are not a relevant risk factor, we find that utilities with an extremely high-emitting fuel mix bear significant risk premiums for carbon which translate to higher cost of capital and a loss of equity value. In contrast, we find no evidence that low-emitting utilities benefit from reduced capital costs. We further reveal that, in addition to the firm's fuel mix, permit allocation rules and replacement investment decisions in terms of fuel technology choice are the driving forces behind the carbon exposure of the utilities. The carbon-related loss of equity value is substantially reduced by implementing an investment strategy directed towards a carbon-free generation mix. The derogations from full permit auctioning in Eastern European member states provide insurance against carbon risks of utilities.