Quantifying Climate Risk Premia

The working paper “Quantifying Climate Risk Premia” develops a framework to quantify how climate change affects financial markets, particularly asset prices and risk premia. It combines a climate module with a long-run risks (LRR) asset-pricing model in order to link climate dynamics with macro-financial variables. The model incorporates both physical climate damages and transition costs associated with policies aimed at limiting global warming. It is calibrated using recent empirical estimates of economic damages and benchmark climate scenarios, particularly the NGFS “Current Policies” pathway.

The framework introduces a persistent temperature state that affects consumption growth. Rising temperatures reduce productivity and therefore consumption growth, while climate mitigation policies generate transition costs. Since the stochastic discount factor in consumption-based asset pricing depends on consumption growth, these channels influence expected returns. The model produces closed-form solutions for the risk-free rate, equity risk premium, and price-dividend ratios under climate risk.

Quantitative results highlight several key findings:

• Risk-free rate declines during rapid warming: Rising temperatures reduce expected consumption growth through climate damages, causing the risk-free rate to fall during periods of rapid warming.

• Risk-free rate returns toward equilibrium as temperatures stabilise: As temperature increases slow and the economy adapts, the risk-free rate gradually converges back to its long-run equilibrium level.

• Climate risks increase the equity risk premium (ERP): Physical climate damages and transition costs substantially raise the compensation investors require for holding equities.

• Magnitude of ERP increase under warming: In a scenario where global temperatures reach about 3°C by 2100, the model estimates that the equity risk premium increases by roughly 20% relative to a counterfactual without climate impacts.

The model also allows economic uncertainty to increase with temperature through temperature-linked stochastic volatility, making the equity risk premium state-dependent. Overall, the results indicate that even gradual, chronic warming can significantly affect expected returns and asset valuations.

The paper concludes that structured asset-pricing models incorporating climate dynamics provide a useful forward-looking tool for analysing how physical risks and transition policies transmit to financial markets, helping investors and policymakers evaluate climate-related financial vulnerabilities and potential market repricing.