We develop an environmental macro-finance model to study how markets price transition and physical climate risks. When carbon taxes are below the social cost of carbon, raising them improves long-run welfare even as it reduces current output. Brown firms perform well in the ``bad economic states" when low taxes let climate damage worsen. This hedging value gives them lower required returns, reversing standard ESG predictions. The green-minus-brown required return can, however, switch sign depending on how policy and climate shocks interact. Strikingly, climate-concerned investors optimally hedge by holding brown stocks, while skeptics hedge with green. More broadly, private hedging motives can diverge from societal climate objectives.

How does carbon pricing affect investment in brown firms? During the period 2000–2019, the effective cost of emitting carbon rose by about 400 percent for Swedish manufacturing firms. Despite lower operating margins, high-emission firms significantly increased both total capital investment and the share of investment dedicated to abatement. The response is concentrated among firms with strong internal financial capacity. We find no comparable investment increase in lower-emitting firms or in high-emission industries outside of Sweden. Our results show that pricing CO2 emissions at a sufficiently high level can incentivize brown firms to make green investments.

In a cap-and-trade system, emitters face transition risk, to the extent that emission caps and permit prices are volatile. We show, theoretically, and empirically for the EU Emissions Trading System, that (i) emitters hedge with emission permits futures bought from financials, (ii) financial constraints limit hedging, in particular by limiting and delaying emitters' purchases of permits in the spot market, implying (iii) permit prices are below the prices of replicating derivatives portfolios. Moreover, we show theoretically that constrained Pareto optima are implemented in equilibrium with cap-and-trade systems, in which the variance of emission caps is set lower than in the unconstrained case.