Pricing climate change risks: CAPM with rare disasters and stochastic probabilities

Christos Karydas (karydasc@ethz.ch) and Anastasios Xepapadeas
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Christos Karydas: ETH Zurich, Switzerland

No 19/311, CER-ETH Economics working paper series from CER-ETH - Center of Economic Research (CER-ETH) at ETH Zurich

Abstract: There are concerns that climate-related physical and political risks are not yet properly reflected in asset prices. To address these concerns, we develop a dynamic asset pricing framework with rare disasters related to climate change. The novelty of this paper lies in linking carbon emissions and portfolio composition with the stochastically-varying probability of these events. Using theory and simulations we study the implications of the imminent threat of climate change on different market measures and on the participation of carbon-intensive assets in the aggregate portfolio, as well as the conditions that lead to these assets becoming stranded. Our result suggest that climate change implies a positive and increasing risk premium, with the overall equity premium depending on the volatility of the stochastic process that governs climate change risk. Transition risks lower substantially the participation of carbon intensive assets in the market portfolio, which should be fully de-carbonized by the end of the century for the worst IPCC emissions scenario.

Keywords: Renewable Climate change; Equity premium; Rare events; Fat tails; Stranded assets (search for similar items in EconPapers)
JEL-codes: E43 G11 G12 Q51 Q54 (search for similar items in EconPapers)
Pages: 34 pages
Date: 2019-01
New Economics Papers: this item is included in nep-ene and nep-env
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Citations: View citations in EconPapers (24)

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