Economic impacts and pricing of climate risk

We find smaller but still negative potential impacts on the equity market after attempting to address known data quality issues in the approach used by the NGFS. There is high model uncertainty. We also review the growing academic literature on how climate risk is priced in markets.

Summary:

• Climate risk affects the economy through physical and transition risks. Financial markets play a role in both allocating capital towards the climate transition and enabling risk sharing by pricing climate risks.
• Further investment is needed to reach emissions reductions that would keep warming below 2 degrees. This results in transition risk, particularly impacting sectors of the economy using and producing fossil fuels. Delays to emissions reductions can increase climate risk in the long term.
• Climate change increases both the acute physical risk from extreme weather and the chronic physical risk from long-run adverse changes to countries’ climate and environment.
•  Scenario analysis can be used to explore the impact of physical climate risk on asset prices. We put together physical climate risk scenarios that closely follow the approach of the NGFS, while attempting to address the known data quality issues in the now retracted Kotz, Levermann, and Wenz (2024) study, used by the NGFS in its Phase V scenarios. With these adjustments, we find smaller but still negative potential impacts on the equity market. There is high uncertainty related to model specifications.
• The academic literature measuring the impact of climate risk on asset prices has expanded significantly, covering different asset classes. Generally, there is evidence of climate risk increasing expected returns, consistent with theory.