Value versus Values: What Is the Sign of the Climate Risk Premium?

Given the conflicting messages about the magnitude and sign of the climate risk premium provided by the empirical studies to date, the author undertakes a theoretical estimation of the sign of the risk premium.

He finds that, in absence of tipping points, the payoff of green (brown) securities covaries positively (negatively) with consumption growth, and should therefore command a positive (negative) risk premium. In a world without sharp and large discontinuities in damages green securities should not therefore be expected to act as effective climate hedges. The picture becomes more complex in the presence of tipping points, with the sign and magnitude of the risk premium now strongly dependent on the strength of the abatement policy, on the location of the critical temperature and on the timing of the payoff. Since the location and magnitude of tipping points is very imperfectly known, this produces a complex message about the net sign and magnitude of the climate risk premium. This could explain the conflicting results from the empirical studies to date.

Keywords: climate risk premium, asset pricing, climate risk hedging