This paper provides an empirical investigation of the effect of the European Union’s Emission Trading Scheme (EU ETS) on the performance of German stock returns. During the first two phases of the EU ETS, emission certificates were granted free of charge allowing firms to emit a given amount of carbon dioxide. We find that firms which received emission allowances  significantly outperformed firms which did not. This suggests the presence of a significant "carbon premium" of up to 15% per annum in portfolios of firms that received EU ETS certificates relative to portfolios of “clean firms”. The performance of carbon portfolios cannot be explained by standard asset pricing models and is unrelated to beta, size and book-to-market ratios.