Pricing climate change risks: CAPM with rare disasters and stochastic probabilities
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Date
2019-01
Publication Type
Working Paper
ETH Bibliography
yes
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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 stochasticallyvarying 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.
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Publication status
published
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Book title
Journal / series
Economics Working Paper Series
Volume
19/311
Pages / Article No.
Publisher
CER-ETH – Center of Economic Research at ETH Zurich
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Edition / version
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Software
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Date collected
Date created
Subject
Climate change; Equity premium; Rare events; Fat tails; Stranded assets
Organisational unit
02120 - Dep. Management, Technologie und Ökon. / Dep. of Management, Technology, and Ec.