This paper presents a financial economic model that analyzes the effects of integrating environmental concerns into investment portfolios in capital markets. The environmentally conscious investor’s expected rate of return on equity is shown to incorporate an environmental risk premium. Both the investors’ degree of concern for environmental externalities and the environmental risk profile of a company are crucial for understanding why companies whose equity values are positively correlated with stricter environmental regulations exhibit a lower cost of equity capital. A closed-form solution to the environmentally-concerned investor is derived, offering insights into how the optimal portfolio relates to both the degree of concern for environmental externalities and the environmental risk profile of an equity stock.
