Climate change risks: pricing and portfolio allocation

Christos Karydas () and Anastasios Xepapadeas
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Christos Karydas: Center of Economic Research (CER-ETH), ETH Zurich, Switzerland (USI), Switzerland

No 19/327, 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 two sources of rare disasters: macroeconomic events and climate change. We link carbon emissions and portfolio composition with the stochastically-varying probability of climate-related 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 market portfolio. We also obtain closed-form solutions for market prices and the Social Cost of Carbon. Our results suggest that climate change implies a positive and increasing risk premium. We also show that, with the observed trends in climate change, macroeconomic risk works as a hedge against catastrophic climate change, such that the aggregate equity premium may remain unaltered. The transition risk of climate policy substantially lowers the participation of carbon-intensive assets in the market portfolio.

Keywords: Climate change; Risk premia; Rare events; Policy Risk; Stranded assets (search for similar items in EconPapers)
JEL-codes: G11 G12 O44 Q51 Q54 (search for similar items in EconPapers)
Pages: 41 pages
Date: 2019-11
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (11)

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