SSRN Id3719139

Climate Finance∗
Stefano Giglio1 , Bryan Kelly2 , and Johannes Stroebel3

1
Yale School of Management, NBER, and CEPR
2 YaleSchool of Management, AQR Capital Management, and NBER
3 New York University, Stern School of Business, NBER, and CEPR
October 26, 2020
Abstract
We review the literature studying interactions between climate change and
financial markets. We first discuss various approaches to incorporating cli-
mate risk in macro-finance models. We then review the empirical literature
that explores the pricing of climate risks across a large number of asset classes
including real estate, equities, and fixed income securities. In this context,
we also discuss how investors can use these assets to construct portfolios that
hedge against climate risk. We conclude by proposing several promising direc-
tions for future research in climate finance.
Keywords: Climate Change, Climate Risk, Physical Risk, Transition Risk, ESG
1 INTRODUCTION
Climate change is one of the defining challenges of our time, with the potential to
impact the health and well-being of nearly every person on the planet. In addition,
climate change poses a large aggregate risk to the economy and the financial system
∗
Prepared for Annual Reviews (www.annualreviews.org). AQR Capital Management is a global
investment management firm, which may or may not apply similar investment techniques or meth-
ods of analysis as described herein. The views expressed here are those of the authors and not
necessarily those of AQR.
Electronic copy available at: https://ssrn.com/abstract=3719139

(see, e.g., Litterman et al., 2020). The tools of financial economics, designed for
valuing and managing risky future outcomes, can therefore help society assess and
respond to climate change risk.
Starting with the seminal work of Nobel Laureate William Nordhaus in the 1970s,
researchers have studied the interactions between climate change and the economy.
Fossil fuels are a critical input to production, so economic growth increases green-
house gas emissions. Those emissions induce climate change, and climate change has
a potentially large negative feedback effect on future economic activity. However,
many important aspects of climate change economics that are financial in nature —
such as the pricing and hedging of risks stemming from climate change, the aware-
ness and attitudes of investors towards these risks, and the effects of climate risks
on investment decisions — have received less attention in the literature. Indeed, it
is only recently that researchers in financial economics have begun to explore these
questions. This burst of research activity constitutes a new and quickly growing field
that we refer to as “Climate Finance.” In this review article, we summarize some of
its theoretical and empirical contributions. We are optimistic that this body of work
will grow in size and influence, and that climate finance will contribute to efforts
across the physical and social sciences to address the challenges of climate change.
Why study climate change through the lens of financial economics? First, risk
and risk preferences play an important role in dictating the optimal policy response
to climate change. Second, financial markets are a primary vehicle for mitigating
and hedging climate risk. They mitigate climate risk by facilitating the flow of
investment capital toward “green” projects, and away from “brown” industries and
firms, as we transition to an environmentally sustainable economy. Examples of the
climate risk-mitigating role played by financial markets include financial innovation
in “green bonds” and a ramp up in “climate-aware” mutual funds. Financial markets
also provide a venue for hedging climate risk. Indeed, one of the most fundamental
functions of financial markets is the sharing and transferring of risks. While climate
risk is an aggregate risk, the heterogeneity in exposure to climate change across
different firms and regions provides valuable risk-sharing opportunities. Likewise,
heterogeneity in adaptability and risk tolerance makes some investors better suited
to bear this risk than others.
Our review of the current literature is organized into two parts. In the first sec-
tion, we discuss efforts to incorporate climate risk into macro-finance models. The
pioneering work of Nordhaus (1977) paved the way for thinking about the interac-
tion of the physical process of climate change with the real economy. Early papers in
this literature — such as Nordhaus (1977, 1991, 1992) — focused on optimal climate
change mitigation, and worked in deterministic settings. As such, these papers did

not directly speak to the ways in which climate change affects asset prices and risk
premia. Subsequent work extends these models to incorporate different aspects of
risk and uncertainty about climate change and its link to the economy. These at-
tributes include the stochastic nature of physical and economic processes as well as
uncertainty about models of these processes (see, for example, the work by Kolstad,
1992, Manne et al., 1992, Nordhaus, 1994, Kelly & Kolstad, 1999, Nordhaus & Popp,
1997, Weitzman, 2001, 2009, Lemoine & Traeger, 2012, Golosov et al., 2014). Much
of this literature has focused on the way risks and uncertainties affect optimal mitiga-
tion policies and the “social cost of carbon.” More recently, the financial economics
literature has explored the implications of these models for the prices and returns of
financial assets.
In the second part of this review article, we discuss the empirical literature that
explores the pricing of climate risk across a large number of asset classes. This
literature considers the price effects of at least two broad categories of climate related
risk factors: physical climate risk and transition risk. Physical climate risk includes
risks of the direct impairment of productive assets resulting from climate change;
transition risk includes risks to cash flows arising from a possible transition to a low-
carbon economy. A central element of the research designs in these papers is that
assets are differentially exposed to these climate risk factors: for example, houses
located near the sea are more exposed to physical climate risks, while coal companies
are more exposed to transition risks. Many papers then combine the differential
exposure of assets within an asset class with time-varying attention paid to climate
risk in order to understand how this type of risk is priced in asset markets. We review
research that documents climate-related asset price effects in equity markets, bond
markets, housing markets, and mortgage markets. We also discuss recent work that
shows how one can use financial assets to construct portfolios that hedge climate
change risks.
2 CLIMATE RISK AND ASSET PRICES: THE-

ORY
To introduce climate change risk into an economic model, the researcher must take
a stand on the main sources of uncertainty associated with the processes of climate
change and the economy. Possible sources include: uncertainty about the future
path of economic activity; uncertainty about the future evolution of the climate;
and uncertainty about the various components of the model itself (e.g., the model
parameters that capture the interaction between the climate and the real economy).

Each source of uncertainty has a different effect on equilibrium prices and risk premia.
To organize the discussion, we begin by providing a stylized framework that helps
highlight the distinction between the effects of uncertainty about the future path of
economic activity and uncertainty about the evolution of the climate process. As
we show, this distinction has radically different implications for asset prices and risk
premia. The model we present here is a simplified version of the one introduced in
Giglio et al. (2020). Like all integrated models of climate change and the economy,
our model specifies both the dynamics of the economy and the physical climate
processes. In the interest of parsimony, both processes are highly stylized versions of
those considered in the physical sciences. Given our interest in asset prices, we also
specify the preferences of investors. We assume a representative-agent Lucas-tree
economy and directly specify the dynamics of equilibrium consumption growth as
well as the dynamics of climate change:
∆ct+1 = µ + xt + Jt+1 , (1)

xt+1 = µx + ρxt + φJt+1 , (2)
λt+1 = µλ + αλt + νxt + χJt+1 . (3)
Equations 1 and 2 describe the evolution of aggregate consumption growth, ∆ct . Jt
is the only shock in this economy; we discuss a number of interpretations of it in
greater detail below. Jt directly affects consumption growth, but it also potentially
affects the other variables in the system. xt represents time-varying expected con-
sumption growth, whose persistence is ρ and whose innovations are also driven by
Jt . The parameter φ captures the way the shock Jt affects the future path of con-
sumption growth, and therefore plays an important role in capturing the dynamics
of consumption and, ultimately, the term structure of risk and risk premia. The
last equation represents the dynamics in the conditional distribution of Jt . In any
given period, Jt+1 could take one of two values: −ξ ∈ (0, 1) with probability λt , or
0 with probability (1 − λt ). This probability itself is time-varying, according to the
dynamics presented in equation 3: in addition to an autoregressive term, it depends
on lagged measures of economic activity (xt ), as well as on the current shock to Jt+1 .
Note that in this simplified framework, there is no uncertainty about the model or
its parameters: so risk in this economy is entirely due to the shock Jt+1 .
While this model is very stylized, it can help us compare and contrast two popular
ways in which the literature has modeled climate risks. The first approach empha-
sizes uncertainty about the path of climate change as a direct source of risk for the
economy. The second approach starts from the observation that the evolution of
the climate and its damages is tightly linked to economic activity; in this approach,

uncertainty about climate damages primarily stems from uncertainty about the fu-
ture path of economic activity. Of course, in practice both channels are likely to
be at play at the same time. We review each channel within the framework of our
one-shock model.
Uncertainty about the path of climate change. We begin by studying the

class of models in which the main source of uncertainty is about the future path
of climate change. The most representative set of papers in this area thinks about
climate risks in terms of a relatively low-probability catastrophic event that could
dramatically impact the economy: a “climate disaster” (Barro, 2013, Weitzman,
2012, 2014, Wagner & Weitzman, 2015). Such a climate disaster is often motivated
by reference to a climate “tipping point.” In the model above, this view coincides
with interpreting Jt as the realization of the climate disaster. The parameter λt
then captures the conditional probability of the climate disaster, and ξ is the size of
the disaster. The occurrence of the climate disaster also affects the future path of
the economy, since it directly affects expected consumption growth xt . Specifically,
when φ > 0, the occurrence of the climate shock reduces not only consumption im-
mediately, but also future expected consumption growth (as in Bansal et al., 2016).
When instead φ < 0, there is partial mean reversion after a climate shock. The latter
case has an especially interesting interpretation when modeling climate change: it
captures the ability of the economy to adapt to climate change and rebuild some
of the lost output at a relatively faster pace (see the emerging literature on adap-
tation to climate change, e.g., Brohé & Greenstone, 2007, Deschênes & Greenstone,
2011, Desmet & Rossi-Hansberg, 2015, Burke & Emerick, 2016, Barreca et al., 2016).
Through the parameter χ, a climate disaster realization also affects future climate
risks λt . Finally, the model allows for feedback effects between climate change and
the economy. Climate risk affects the economy (when the climate disaster occurs),
and economic activity affects climate risk through the effect of xt on λt (modulated
through the parameter α): when economic activity is high, climate risk increases.
But when the climate shock materializes, consumption is low. In this model, there
is no additional source of uncertainty about the path of economic activity beyond
what is due to the climate shock.
Uncertainty about the path of the economy. As the early literature in cli-
mate economics points out, economic activity is itself a driver of climate change,
so uncertainty about economic growth generates uncertainty about climate change.
In this vein, the typical model embeds chains of events of the following form: the
economy experiences a positive growth shock, pollution increases alongside output,

the increase in CO2 emissions accelerates climate change, which in turn accelerates
climate-related damages on the economy (Nordhaus, 1977, 1991, 1992). In short,
higher growth today associates with larger negative effects on future growth through
the climate feedback channel. Conversely, negative shocks to economic activity (as
recently experienced during the COVID-19 crisis) instead results in less pollution
and less climate-related economic damage.
This model view can be represented in the one-shock model above by interpreting
Jt as a shock to economic activity. A standard specification for climate change
damages (e.g., Nordhaus & Boyer (2000) and Nordhaus (2008)) posits that they scale
up with consumption. Suppose first that climate damages are a constant fraction
of consumption, that is, they are Qt = τ Ct . Then, equations 1 and 2 represent
the dynamics of net consumption (that is, aggregate consumption net of the climate
change damages), Jt is a standard shock to economic activity, and equation 3 captures
the time-varying distribution of economic activity. As discussed in Giglio et al.
(2020), the case in which the climate-related output tax varies over time (Qt = τt Ct ,
with τt time-varying) is also nested in these equations by appropriately changing the
dynamics of xt .
Asset pricing implications. The discussion above highlights that equations 1–

3 nest two common paradigms for embedding climate risks in economic models:
uncertainty about climate disasters versus uncertainty about economic activity and
its climate feedback effects. Once the physical processes of consumption, climate
change, and climate damages are determined, the model is completed by choosing
a utility function for the representative agent. This implies a stochastic discount
factor for the economy, which in turn implies equilibrium asset prices. From here,
this toy model can be enriched in many dimensions, for example by introducing
heterogeneity, production, governmental climate policies, and realistic information
sets for agents inside the model.
We first review a number of asset pricing implications of the two models presented
above. The conclusions in this section are derived under power utility, as in Giglio
et al. (2020). Before focusing on the central differences between the two modeling
approaches, let us begin by pointing out a common implication. Whether uncertainty
is directly about the climate or indirectly about climate through economic activity
and feedback effects, realized climate damages have negative effects on the sectors
of the economy exposed to that risk. Put differently, in both models, an asset with
positive exposure to climate risk will decline in value when an adverse climate shock
occurs, whatever the origin of that shock.
The two modeling paradigms, however, have starkly different implications for risk

premia associated with climate damages. We discuss implications for both the level
and the term structure of discount rates. A number of other forces that are not
easily captured by our stylized model – such as alternative preference specifications
and model uncertainty – can also affect risk premia, and we discuss these forces in
more detail below.
When the uncertainty emanates directly from the climate process itself (e.g., in
climate disaster models), climate damage tends to be unexpectedly high in times
when consumption is low because climate disaster realizations are a primary driver
of reduced consumption. Assets that are positively exposed to climate risk — that
is, assets with low payoffs when climate damages are high — thus tend to require
positive risk premia. On the other hand, assets that are negatively exposed to climate
risk — such as marginal mitigation and hedging investments that pay off primarily
when climate damages are realized — will have negative risk premia since these assets
provide an insurance against bad (high marginal utility) states of the world. This has
important implications for the appropriate discount rates used to value mitigating
investments. For example, consider an investment that reduces CO2 emissions by
one ton today, the value of which is often referred to as the “social cost of carbon.” In
climate disaster models, the social cost of carbon is relatively high, because payoffs
to investments that mitigate climate damages are discounted at rates lower than the
risk-free rate.
On the other hand, if the main source of uncertainty is instead about the path
of the economy, the climate risk premium has the opposite sign. In these models,
climate damages are assumed to be larger when the economy is performing better.
An investment that mitigates climate damages tends to pay off in times when con-
sumption is high and marginal utility is low. Therefore, these investments carry
positive risk premia and should be discounted at rates above the risk-free rate. In
these models, the associated social cost of carbon is then relatively low. The low
value of climate mitigation investments reflects the agent’s unwillingness to pay for
mitigation because it pays off in good times when marginal utility is low. Lemoine
(2015) explains this channel as follows: “Under conventional damage specifications,
the consumption losses due to climate change increase in the level of consumption.
As a result, emission reductions increase future consumption by a larger amount
when future consumption is otherwise high. This mechanical correlation between fu-
ture consumption and the future consumption benefits of emission reductions makes
emission reductions seem like an especially risky investment and therefore works to
reduce the policymaker’s willingness to pay for emission reductions.”
In addition to the sign of the risk premium, the stylized model also also allows us
to explore how the term structure of risk premia is affected by different assumptions

about the term structure of the riskiness of cash flows. Consider an investment
that can mitigate the effects of climate change at some point in the future. As we
discussed above, this investment commands a negative risk premium if uncertainty
stems directly from the climate path, and a positive risk premium if uncertainty
stems from the path of economic activity. But how do these premia vary along
the term structure (i.e., along the horizon at which the benefits of the investment
materialize)? The answer depends on the dynamics shocks in the model.
First, we assume that shocks to expected growth are persistent, ρ > 0, as in
most dynamic macro-finance models. Next, if φ > 0, there are long-run risks in
consumption, since today’s shock J also affects consumption growth in the future
in the same direction. In that case, long-term assets are more exposed to climate
shocks than short term assets. Long-term discount rates are then larger (in absolute
value) than short-term discount rates. If the primary source of uncertainty is about
the climate path, risk premia for climate mitigation investments are negative and
become even more negative at longer horizons. If the primary uncertainty is about
the path of economic activity, discount rates are positive in the short term and
become increasingly positive with the horizon.
Alternatively, if φ < 0, then the economy recovers quickly from a negative shock
J, growing faster than average during the recovery. In that case, long-term assets
benefit from a recovery in a way that short-maturity assets do not. Because of
this, the future is less risky, and risk premia revert toward zero as horizon increases.
If uncertainty is about the climate path, risk premia for climate mitigation starts
negative but increase with the horizon. If uncertainty is about the path of economic
activity, risk premia are positive at short horizons but decrease with the horizon.
In our stylized model with power utility, the level and term structure of discount
rates are only driven by different assumptions about the term structure of the cash
flow risk. As a result, empirical evidence on the term structure of discount rates of
assets exposed to climate risk allows researchers to discipline the cash flow processes
in equations 1–3. In particular, recent advances have been made in estimating the
term structure of discount rates for equities (Binsbergen et al., 2012, Van Binsbergen
& Koijen, 2017, van Binsbergen et al., 2013) and real estate (Giglio et al., 2015, 2020),
both of which are asset classes that are exposed to climate risk (see the next section).
For both asset classes, researchers have found positive risk premia that decline with
the horizon. A central insight from Giglio et al. (2020) is that these patterns speak in
favor of a version of our model along the “climate disaster” lines, where the primary
source of uncertainty is the path of climate change, combined with partial mean
reversion of the economy following a climate shock (φ < 0), perhaps because of an
ability of the economy to adapt to the new climate.

To sum up, the debate around the term structure of discount rates for valuing
investments to mitigate climate change (and its effects on the social cost of carbon)
can in large part be traced to different assumptions about the nature of the shocks
that mitigation investments are hedging, and about the dynamics of the economy
and the climate in response to those shocks. While this two-dimensional distinction
does not fully span the variety of models that have been written in the literature,
it helps to understand what has lead the literature to reach different (sometimes
opposite) conclusions.
So far we have focused on discussing the asset pricing implications of climate
change that result from different specifications of the shocks and of the dynamics
of the processes. However, researchers have explored additional forces that also
affect risk premia and their term structures, such as preferences and uncertainty. As
highlighted by a recent literature, drawing meaningful conclusions on the level and
term structure of risk premia for climate investments requires taking a stand on the
model in its entirety (see Gollier & Weitzman, 2010, Traeger, 2013, Arrow et al.,
2013). We next discuss in turn how preferences and uncertainty affect climate risk
premia.
Preferences. Preferences for time and risk naturally play an important role in
determining discount rates and their term structure.
First, it is important to establish the rate of pure time preference. Stern (2007)
took the view that ethical considerations should dictate this rate, and suggested
using a pure time preference coefficient of effectively zero, giving the same weight
to all generations. Most of the literature, such as Nordhaus (2007) and Weitzman
(2007), has instead argued for using rates of pure time preference that are greater
than zero, consistent with observed savings and investment behavior (see also the
discussion in Arrow, 1995).
In addition, the climate finance literature has explored a number of alternative
risk preferences. The most prominent alternative to power utility is Epstein–Zin
utility (see, for example, the work of Gollier, 2002, Crost & Traeger, 2014). An
Epstein–Zin investor’s marginal utility depends not only on the one-period innovation
in consumption growth (as in the power utility case that we described above) but
also on news about consumption growth at future horizons. This specification of
preferences has two main consequences for thinking about climate risks (for suitable
parameterizations that induce a preference for early resolution of uncertainty): first,
it affects the level of climate risk premia, because it amplifies the utility consequences
of climate shocks if they have long-term implications for the agent’s consumption
growth (as they do, for example, in Bansal et al., 2019). Second, they affect the term

structure of discount rates, as well as the optimal timing of mitigation investments.
For example, Daniel et al. (2019) show that Epstein–Zin preferences increase the
value of mitigating climate change early, and result in declining paths of CO2 prices
over time, as uncertainty gets resolved.
Model Uncertainty. The vast majority of asset pricing theory is formulated under
the assumption of rational expectations, so that investors inside the model know
the exact probability laws that govern their decision making environment. The
illustrative model introduced above is an example of this modeling approach. But
in the context of climate change (and likely more generally), rational expectations
endow investors with an unrealistic understanding of their environment. As Hansen
(2014) emphasizes, “it is often not clear what information should be presumed on
the part of economic agents, how they should use it, and how much confidence they
have in that use.” Put differently, in rational expectations models, investors face the
uncertainty about stochastic realizations from a known probability law. In reality,
investors also wrestle with ambiguity, or uncertainty about the true probability law.
Nowhere could this be truer than in economic models of climate risk. Is it implausible
that economic agents know with any degree of certainty the precise nature or severity
of climate risks that are facing them, a topic of substantial disagreement even within
the scientific community. As Lemoine (2020) aptly notes,
“Uncertainty is fundamental to climate change. Today’s greenhouse gas

emissions will affect the climate for centuries. The emission price that
internalizes the resulting damages depends on the uncertain degree to
which emissions generate warming, on the uncertain channels through
which warming will impact consumption and the environment, on the
uncertain future evolution of greenhouse gas stocks, and on uncertain
future growth in productivity and consumption.”
Recent climate-economic theory begins to confront ambiguity in climate economic

models using tools from the theory of decision under uncertainty. Brock & Hansen
(2018) and Heal & Millner (2013) lay out the general argument for, and technical
approaches to, featuring model uncertainty in climate economic models. Heal &
Millner (2013) catalogs the sources of ambiguity as “scientific uncertainty” (e.g., the
effect of atmospheric CO2 concentrations on surface temperatures) versus “socio-
economic uncertainty” (e.g., even if we knew the model for the climate effects of
CO2 , we remain uncertain about how societies react to these effects). Surveying
predictions from a wide range of climate research and meta-analyses, Brock & Hansen
(2018) illustrate wide heterogeneity in forecast distributions among leading climate
10

Figure 1: Temperature Forecasts From Various Climate Models
Source: Climate Lab Book (http://www.climate-lab-book.ac.uk/).
models. As an example, Figure 1 shows the divergence in forecasted temperature

anomalies across several models and across parameter values within those models.
In models of ambiguity, investors typically assign probability weights to models in
a Bayesian fashion based on a combination of their prior model weights and the data
they have observed. Investors make savings and consumption decisions based on the
compound uncertainty they face based on their posterior weights over models and
the stochasticity within each model. Preferences interact with ambiguity through
recursive preferences or, more directly, through robust or ambiguity averse prefer-
ences. Brock & Hansen (2018) outline a range of potential modeling choices for the
specific forms that model uncertainty might take and for the preference or decision
theoretic constructs that agents in the model use to make savings and consumption
choices in the face of uncertainty.
Lemoine (2020) argues that accounting for model uncertainty leads to higher
estimates of the social cost of carbon than would otherwise prevail. In models
with recursive preferences, uncertainty (especially with regards to economic dam-
ages arising from temperature increase) raises the social cost of carbon by an order
of magnitude relative to a model with the same preference structure but no ambigu-
ity. Parameters that govern climate-related economic damages are random variables
when approached from a model uncertainty viewpoint. Uncertainty thus introduces
a new channel that impacts asset prices in the form of covariance between model
parameters and agents’ consumption. This induces precautionary savings and risk
11

premia effects in addition to those resulting from stochastic shocks in standard un-
ambiguous models. Viewing damage uncertainty as a compound lottery, when the
agent “draws” an especially adverse damage parameter, carbon mitigation becomes
especially valuable and raises the social cost of carbon (as long as relative risk aver-
sion is greater than one, as commonly assumed in calibrations of macro and finance
models).
In the face of model uncertainty, Bayesian economic agents gradually update their
beliefs about their environment based on the arrival of new data. Since Bayesian
posteriors follow a martingale, these updates constitute permanent shocks from the
perspective of the learner. As Johannes et al. (2016) and others point out, these
belief update shocks are especially risky for agents with recursive preferences and, as
a result, risk premia are magnified relative to baseline models with no ambiguity or
with non-recursive utility. This “learning as a long-run risk” perspective motivates
the measurement of climate risk through news arrival in the empirical analysis of
Engle et al. (2020) discussed in Section 3. The persistent effects of belief updating
leads model uncertainty to accumulate over time, partially offsetting the effects of
discounting on damages in the distant future. This mechanism is at the core of the
large increase in the social cost of carbon in Lemoine (2020).1
Once we acknowledge that agents in a climate model face ambiguity, it is natu-
ral to consider decision theoretic frameworks beyond subjective expected utility in
order to accommodate the well documented human tendency of ambiguity aversion
(Ellsberg, 1961). As a leading example, Barnett et al. (2020) analyze the social cost
of carbon under model uncertainty while accounting for ambiguity aversion. In their
setup, ambiguity takes the form of multiple potential models of the impact of car-
bon emissions on temperature and economic damages caused by high temperatures.
Agents make decisions amid this ambiguity based on the recursive smooth ambigu-
ity aversion preferences of Hansen & Miao (2018). While the comparative statics in
Lemoine (2020) analyze incremental carbon costs associated with model uncertainty
in an expected utility framework, Barnett et al. (2020) analyze the additional incre-
mental effects of ambiguity aversion on the social cost of carbon. Holding fixed the
extent of model uncertainty, they compare model calibrations with ambiguity averse
investors versus a model with ambiguity neutrality. Ambiguity aversion magnifies
1
A similar model analyzed by Dietz et al. (2018) calibrates a comparatively small cost of car-
bon, arguing that “the positive effect on the climate beta [covariance of consumption and the
marginal social cost of emissions] of uncertainty about exogenous, emissions-neutral technological
progress overwhelms the negative effect on the climate beta of uncertainty about the carbon-climate-
response.” Lemoine (2020) chalks this difference up to the larger model uncertainty used in his
calibration compared to that of Dietz et al. (2018).
12

the cost of carbon by roughly 60% to 70% in current value terms relative to the
baseline scenario with model uncertainty but ambiguity neutrality.2
3 CLIMATE RISK AND ASSET MARKETS: EM-

PIRICAL EVIDENCE
In recent years, the finance literature has made substantial progress in understanding
the effects of climate change on asset prices across a number of asset classes. This
research effort has the immediate benefit of helping us quantify the forces that link
the climate and the economy, and therefore allows us obtain a better understanding of
the underlying structural relationships discussed in the previous section. In addition,
we will show that understanding the empirical relationship between climate change
and asset prices has the benefit of giving us implementable indications on how to use
financial markets to hedge climate risks.
For researchers interested in understanding the effects of climate change on asset
prices, it is important to note that there are actually several different categories
of climate risks potentially priced in asset markets, and that these different risks
often do not materialize at the same time. Broadly speaking, climate risks can be
divided into physical risks and transition risks. The physical risks of climate change
are those that result directly from the effects of changes in the climate on economic
activity. For example, the threat of damage from rising sea levels to firms’ production
facilities close to the sea, and the associated destruction of real estate values, would
be considered a physical climate risk. Transition risks cover a wide range of effects
on firms’ operations and business models that come from a possible transition to a
low-carbon economy. One example of a transition risk is the possible introduction of
a carbon tax that might leave fossil fuel companies with stranded assets that are no
longer profitable to operate. In addition to such regulatory risks, transition risks also
include technological advances and changing consumer preferences away from high-
carbon activities. While realizations of physical and transition risks need not occur at
the same time, they are often correlated, and might even move in opposite directions.
For example, the introduction of a carbon tax — a realization of negative transition
2
Barnett (2017) also pursues this line of research to understand asset prices and production when
agents have both recursive preferences and aversion to uncertainty about the climate model. He
analyzes a dynamic general equilibrium model where production involves a mix of cheap, polluting
fossil fuels and expensive, clean green energy. Accounting for aversion to climate model misspecifi-
cation increases the market price of climate risk in the model by as much as an order of magnitude
relative to a model with no ambiguity aversion.
13

risk — might reduce the likelihood of future negative realizations of physical climate
risks.
Different assets may be positively or negatively exposed to these types of climate
risks; in other words, realizations of both physical and transition risks will have win-
ners and losers in asset markets. For example, while coal companies would likely
suffer from realizations of transition risks, renewable energy companies might bene-
fit. And while climate change will negatively affect the value of coastal real estate, it
might also increase the value of farmland in colder regions of the world. Given these
different risk categories, and the different exposures of various assets to these risk
categories, one of the important common challenges for all approaches to exploring
how climate risks affect asset markets is to obtain measures of different assets’ ex-
posures to both physical and climate risks. Our discussion below will highlight how
different researchers have approached this challenge.
A second important challenge to documenting how climate change is priced in
asset markets is that the rise in investor attention to climate risk is a fairly recent
phenomenon. As a result, while climate risk may be priced in asset markets today,
it might not have been 10 or 15 years ago. This reduces the ability of researchers to
exploit time series variation in documenting how climate change affects asset prices.
In addition, the availability of only a short time series makes it hard to estimate the
climate risk premium, which, as we saw in the previous section, plays a fundamental
role in distinguishing between theories. As a result, our understanding of the pricing
of climate risks in financial and non-financial assets is likely to evolve substantially
over the coming years, as more time series data become available.
3.1 CLIMATE RISK AND FINANCIAL ASSETS

A number of papers have explored the extent to which climate risks are priced in
financial assets. This literature often starts from the observation that a growing
number of large institutional investors have declared environmental, social, and cor-
porate governance (“ESG”) sustainability an important objective in their portfolio
allocation process. Naturally, climate change is a focal issue in ESG investing. For
example, Larry Fink of BlackRock wrote in his 2020 letter to CEOs that “our invest-
ment conviction is that sustainability- and climate-integrated portfolios can provide
better risk-adjusted returns to investors.” He concludes that, in response to climate
change, “in the near future – and sooner than most anticipate – there will be a
significant reallocation of capital.” This statement is consistent with the systematic
analysis of presented in Krueger et al. (2020). These authors conduct a survey of
active investment managers to explore their approaches to managing climate risk.
14

They find that investors believe that climate change has significant financial implica-
tions for portfolio firms, and that considerations of climate risk are important in the
investment process. For example, 39% of investors in the survey reported to be work-
ing to reduce the carbon footprints in their portfolios. These survey responses are
also consistent with findings from Alok et al. (2020), who show that fund managers
adjust their portfolios in response to climatic disasters. Pedersen et al. (forthcoming)
provide an ESG CAPM framework and outline how investor beliefs and preferences
regarding climate change risks (and ESG considerations more broadly) fit in with
the factor model paradigm that dominates empirical asset pricing research.
Equity Markets. Given the attention that investors dedicate to climate change,
a growing literature explores the pricing of various dimensions of climate risk in
equity markets (e.g., Hong et al., 2019). Much of this literature has focused on the
effects of regulatory climate risk, where different measures of carbon intensity or
environmental friendliness are often used as proxies for regulatory climate risk.3 For
example, Bolton & Kacperczyk (2020) analyze U.S. equity markets, and demonstrate
that firms with higher carbon emissions are valued at a discount. Quantitatively, the
authors estimate that a one standard deviation increase in emissions across firms is
associated with a rise in expected returns of roughly 2% per annum. The authors
trace this effect at least in part to exclusionary screening performed by institutional
investors to limit the carbon risk in their portfolios. In related work, Hsu et al. (2020)
show a similar spread in average returns between high- and low-pollution firms, and
link it to uncertainty about environmental policy. Engle et al. (2020) document that
stocks of firms with high E-Scores — which the authors argue capture lower exposure
to regulatory climate risk — have higher returns during periods with negative news
about the future path of climate change. Similarly, Choi et al. (2020) explore global
stock market data and find that stocks of carbon-intensive firms underperform during
times with abnormally warm weather, a period when investors’ attention to climate
risks are likely to be particularly high. Barnett (2020) uses an event study analysis
to explore financial market impacts of regulatory risk. He finds that increases in
the likelihood of future climate policy action lead to decreased equity prices for
firms with high exposure to climate policy risk. Similar evidence of the pricing of
climate risk can be found in equity options markets. Ilhan et al. (2019) show that
the cost of option protection against extreme downside risks is larger for firms with
more carbon-intense business models, and particularly so at times when there is an
increased public attention to climate risk.
3
A number of recent papers have attempted to provide new measures of firm-level exposures to
climate risk that are based, for example, on the language around climate change used in earnings
calls (Sautner et al., 2020, Li et al., 2020).
15

In addition to climate change affecting firm valuations through the exposure of
their business model to various forms of climate risk, investors also appear to reward
firm efforts to mitigate these risks. For example, Pérez-González & Yun (2013) study
the effects of managerial efforts to mitigate firms’ climate risk exposures on those
firms’ valuations. Based on firm-level weather hedging data (using CBOE weather
contracts), they show that climate hedgers have higher valuations, and that this
effect is more pronounced for more climate sensitive firms. This is consistent with
findings from the survey in Krueger et al. (2020), which highlighted that investors
were actively engaging with management — both informally and formally through
shareholder proposals — to work with them to reduce their climate risk exposures.
Fixed Income Markets. Climate risks may also affect financial assets beyond
equities. Municipal bond markets are a particularly interesting setting for analyzing
the financial market implications of climate risk. In particular, when considering the
physical risks of climate change, firms may be at risk depending on the location of
their production facilities. However, even the most exposed firms usually have the
option of relocating their modes of production to other geographies. Municipalities
have no such luxury. As a result, one would expect that municipal debt backed by
tax revenues from localities more exposed to physical climate risks such as rising sea
levels or wildfires would trade at a substantial discount. In evidence along these lines,
Painter (2020) shows that at-issuance municipal bond yields are higher for counties
with large expected losses due to sea level rise (SLR). Consistent with the hypothesis
that such price differences reflect the pricing of climate risk, he finds that this effect
is concentrated in long-dated bonds and essentially absent at short maturities over
which the likelihood of SLR remains low. In related work, Goldsmith-Pinkham et al.
(2019) show via a structural model that this effect of SLR on municipal bond yields
is tantamount to a 3–8% reduction in the present value of local government long-run
cash flows.
Climate risk may also be priced in other fixed income markets, such as the cor-
porate bond markets studied by Huynh & Xia (2020). These authors first calculate
the covariance of each bond’s returns with the climate news index constructed by
Engle et al. (2020). Bonds with a more positive covariance are those that perform
relatively well when bad news about climate change emerges, suggesting they are
weakly or even negatively exposed to realizations of climate risk. Consistent with
climate risk being priced in corporate bond markets, Huynh & Xia (2020) find that
those positive-covariance bonds have lower returns.
Another class of fixed income assets with valuations that might be affected by
climate risk are “green bonds” whose proceeds are expressly linked to environmen-
tally friendly projects (e.g., renewable energies, clean transportation, etc.). Baker
16

et al. (2018) study a sample of more than 2,000 municipal and corporate green bonds
and find that green bonds trade at lower yields than bonds with similar attributes
that lack a green designation. Quantitatively, after-tax yields at issue for green
bonds are roughly 6 basis points below yields paid by otherwise non-green equivalent
bonds. The authors attribute these pricing differences to a subset of investors that
have a nonpecuniary component of utility, such as a sense of social responsibility
from holding green bonds. Realizations of climate risk may move the magnitude of
this nonpecuniary valuation component, and will thus affect the valuations of these
bonds.
Hedging Climate Risks Using Financial Assets. The research described
above shows that climate change is a significant risk factor determining asset prices.
This observation then invites the question of how investors can mitigate the risks that
climate change poses to their portfolios. This is particularly important since many
of the effects of climate change are sufficiently far in the future that neither financial
derivatives nor specialized insurance markets are available to directly hedge those
long-horizon risks. Instead, investors are largely forced to insure against realizations
of climate risk by building hedging portfolios on their own.
Engle et al. (2020) propose an approach to hedging climate risk that combines
traditional dynamic trading arguments from financial theory with novel statistical
measurements using textual analysis. The paper’s first insight follows the Black &
Scholes (1973) and Merton (1973) logic that a dynamic strategy to hedge gradually
arriving news about future climate change can approximately replicate an infeasible
contract that directly pays off in the event of a future climate disaster. The key
question, then, is: how to measure such news? To do this, Engle et al. (2020) extract
a “climate news” index based on coverage of climate change by The Wall Street
Journal (WSJ). The index — which is available to other researchers, and which has
been used by Huynh & Xia (2020) and others — measures the extent to which WSJ
article text overlaps with climate change discourse in authoritative texts published
by various governmental and research organizations. The index, shown in Figure 2,
displays intuitive variation over time. The level of climate news coverage gradually
rises over time and spikes around topical global climate events. In their baseline
approach, Engle et al. (2020) interpret rising coverage of climate related topics as
the arrival of bad news about future climate change. They validate this approach by
complementing their WSJ-based analysis with additional sentiment-based studies of
climate coverage in newspapers.
With this measure of the arrival of climate news, Engle et al. (2020) propose an
approach to dynamically hedging climate news based on factor mimicking portfolios.
Specifically, the authors use relatively easy-to-trade basis assets (U.S. equities) to
17

Figure 2: Climate Change News Index
225 2009 Copenhagen

UN Climate Change
Conference Trump
Withdraws from
200 Paris Agreement
175
3rd National Climate
Assessment &
EPA Climage Change
G8 Climate Agreement Initiative
150
Adoption of Paris
WSJ
UNFCCC 4th IPCC Report Agreement

2012 Doha
125 UN Climate Change
Bush withdraws from Conference
Kyoto Protocol
Kyoto Protocol
100 Adopted Kyoto Protocol
IPCC Formed Effective
UNFCCC meets
NOAA produces Treaty
75 educational film about Requirement
global warming
"The Climate Factor"
50
25
1985 1989 1993 1997 2001 2005 2009 2013 2017
DATE
Source: Engle et al. (2020).
mimic the WSJ climate news index. Intuitively, the approach is to systematically
own or overweight stocks that rise in value when (negative) news about climate
change materializes and likewise short or underweight stocks that fall in value on the
arriveal of this news. In doing so, the hedge portfolio profits when adverse climate
news hits. The authors show how to continually update the hedge portfolio using
evolving information about which stocks are most susceptible and which are most
resilient to climate risk.
To implement this dynamic hedging strategy, it is necessary to determine which
firms increase or decrease in value when there is news around climate change. Engle
et al. (2020) solve this problem by proxying for firms’ climate risk exposures using
“E-Scores” that capture various aspects of how environmentally friendly a firm is.
The hedge portfolio would then overweight high-E-Score firms, and underweight low-
E-Score firms, with the relative weights updated dynamically as more data on the
relationship between E-Scores, climate news, and asset prices is obtained. While it is
straightforward to construct such a hedge with the benefit of hindsight, the true test
of a hedge portfolio is its ability to profit in adverse conditions on an out-of-sample
basis. Indeed, Engle et al. (2020) find an out-of-sample correlation of 20% to 30%
between the return of the hedge portfolio and innovations in the WSJ climate change
18

news index. In summary, the paper provides a rigorous methodology for constructing
portfolios to hedge against climate risks that are otherwise difficult to insure.
It is worth pointing out an additional connection between this empirical approach
and the theories discussed in the previous section. If uncertainty about future climate
damages (for example, about the model parameters) is resolved slowly over time, then
the news about the future path of the economy will itself represent a risk factor for
the investor. A portfolio that hedge the news about future climate, like the one
built by Engle et al. (2020), would then be useful not only to dynamically hedge
the long-term realization of the damages from climate change, but also to hedge
the risks represented by the arrival of information over time (resolution of model
uncertainty). This provides an additional advantage of this hedging portfolio (one
that would be particularly valuable for investors, like Epstein–Zin investors, that are
especially averse to such news shocks).
Finally, mimicking portfolios are closely related to risk premia. As is well known
from the asset pricing literature, the risk premium of any nontradable risk (like
climate change risk) is the expected excess return of the corresponding hedging port-
folio.4 Once the hedging portfolio for climate risks is built, therefore, one could
estimate the climate risk premium by looking at the time-series average return of
this portfolio. As highlighted above, however, this exercise is difficult with a short
time series. For example, suppose that the true climate risk premium is positive,
as many of the models reviewed in the previous section imply. The climate-hedging
portfolio should then have a negative risk premium: its average return should be, in
the long run, below the risk-free rate. However, if one computes the average return
of this hedging portfolio over the last 10-15 years, one might as well find a positive
average return, because this short time period is dominated by the realization of a
series of bad news about climate change (see Figure 2). This would then lead to
estimating the wrong sign for the climate risk premium. Given the short time se-
ries available, it is important to keep these caveats in mind when interpreting the
historical average returns of climate-exposed portfolios.
3.2 CLIMATE RISK AND HOUSING AND MORTGAGE

MARKETS
A growing literature has started to explore the effects of climate change on real estate
valuations, and through this channel, on the mortgage market. This focus on real
estate is hardly surprising. Indeed, since the value of real estate is tightly linked to
4
The hedging portfolio can be constructed either directly, via mimicking-portfolio regressions,
or indirectly, for example using two step cross-sectional regressions.
19

the value of the land it is built on, it is natural to suspect that physical climate risk
factors, such as rising sea levels and wildfires, might directly affect real estate prices.
Take rising sea levels as an example: Hauer et al. (2016) estimates that a 1.8 meter
sea level rise by the year 2100 would affect about 13.1 million Americans. Similarly,
Zillow economist Krishna Rao (2017) calculates that a six feet sea level rise would
put 1.9 million homes worth about $882 billion at risk of flooding, with about half
the losses coming from Florida alone. While many of these damages might only arise
some decades in the future, the low long-run discount rates for real estate discussed
in the previous section mean that present-day real estate prices might already be
significantly affected by climate risk.
To explore whether or not climate change risk is priced in real estate today, one
would ideally want to compare the valuations of two otherwise identical properties
that are differentially exposed to physical climate risk factors such as rising sea
levels, flooding, hurricanes, or wildfires. The challenge with this empirical exercise
is that all houses are, by nature, a unique combination of aspects of location and
structure (Kurlat & Stroebel, 2015, Piazzesi et al., 2020), which complicates the
search for comparable units that might be differentially exposed to climate risk.
More problematic still, some of the locational or structural aspects that contribute
to the value of a particular property might correlate with the property’s exposure to
climate risk. To give a concrete example: properties with beach access are likely to
be more exposed to rising sea levels than properties that are located further inland.
And, since beach access is a valuable amenity, beach front properties will usually
trade at a premium relative to other properties. This does not mean, however, that
climate risk is not priced. Instead, it means that the particular location of the
property has both a positive amenity value, which increases the flow utility from the
property, and is associated with higher climate risk, which affects the realization and
valuation of future cash flows. While hedonic regressions allow researchers to control
for observable differences in quality features of properties, such as the property’s
size, many important location features are hard to measure and therefore difficult to
completely control for in a regression.
Many of the researchers studying whether climate risk is priced in real estate
markets therefore exploit additional sources of variation, often time-series variation
in climate risk, beyond the across-property variation in climate risk exposures. The
identifying assumption in these analyses is the following: as long as the amenity
value of beach access does not change when climate risk changes, differential price
changes of more-exposed and less-exposed properties can be informative about the
pricing of climate risk in housing markets. However, such an analysis presents a
second challenge: true climate risk is a relatively slow-moving object that does not
20

provide much of the high-frequency time-series variation required to identify how
it is priced using the approach just described. Researchers have therefore tried to
exploit time-series variation in the attention to climate risk in the housing market.
Indeed, even though true climate risk might not change much from year to year, the
extent to which housing market participants focus on these risks changes much more
frequently, and one would thus expect the pricing implications of climate risk to be
particularly strong when households pay more attention to these risks
A recent paper using a research design along these lines is Giglio et al. (2020).
They explore the pricing of the risk of rising sea levels in four coastal U.S. states
— Florida, New Jersey, North Carolina and South Carolina — that are particularly
exposed to this physical climate risk factor. To measure different properties’ exposure
to climate risk, the authors geo-code the addresses of all properties bought and
sold in these states between 2008 and 2017. They then map the property locations
to information provided by the National Oceanic and Atmospheric Administration
(NOAA) that indicates which regions will be flooded should sea levels rise by six
feet or more. The authors document substantial variation in exposure to climate
risk across properties in the same narrow geography. This variation is driven, for
example, by differences in elevation, and allows the authors to compare the pricing
of climate risk while holding local housing market conditions fixed.
To identify the pricing of climate risk, Giglio et al. (2020) also construct a mea-
sure of attention paid to this risk in housing markets. To construct this measure,
which varies across both time and space, the authors analyze the textual descriptions
of properties in the universe of for-sale and for-rent property listings from Zillow, a
major online real estate listings service. The resulting “Climate Attention Index”
is constructed by calculating the proportion of for-sale listings with property de-
scriptions that contain climate risk-related words and phrases such as “hurricanes”,
“FEMA”, “floodplain”, and “flood risk.”Most of the flagged listings include descrip-
tions that highlight that a specific property is less exposed to climate risk (e.g., “Not
in a flood zone, it’s high and dry!”). This is unsurprising: if you are selling a house
that is not exposed to climate risk, this is something worth highlighting in a property
listing, in particular in areas and at times when potential buyers pay more attention
to these risks. In terms of spatial variation, more attention to climate risk is paid
in coastal regions, which have a higher average exposure to these risks. In the time
series, attention to climate risk increases after salient natural disasters. For example,
the Climate Attention Index in New Jersey increases substantially between 2011 and
2013, around the time of Hurricane Sandy, which rendered 20,000 homes in the state
uninhabitable.
Using these data, Giglio et al. (2020) show that while properties in a flood zone
21

generally trade at a premium compared to otherwise similar properties (likely because
of positive amenities such as beach access), this premium compresses in periods with
elevated attention paid to climate risk. Quantitatively, a doubling in the Climate
Attention Index (i.e., a doubling in the share of listings that mention climate risk-
related words) is associated with a relative 2.4% decline in the transaction prices of
properties in the flood zone.
One possible concern with these results is that they might not just capture the
pricing of future climate change risk. Instead, these estimates might also pick up
changes in the flow-utility of climate risk-exposed properties that could be correlated
with climate risk attention. For example, as discussed above, it appears to be the
case that climate risk attention rises after hurricanes; if those hurricanes also have
a particularly strong direct effect on the utility of living in properties located in
flood zones, this might explain the relative price decline of these properties. Giglio
et al. (2020) rule out such a story, by showing that the relative rents of properties
more exposed to climate risk do not decline when attention to climate risk increases.
Since any decline in the flow-utility from exposed properties that is correlated with
increases in climate risk attention would also affect these rental units, this finding
emphasizes that the relationship between climate risk attention, climate risk expo-
sure, and price is driven by changes in the expected realization and valuation of
future cash flows (rents).
A number of other papers exploit related research designs to explore the pricing of
climate risk in real estate markets. Bernstein et al. (2019) also explore the relation-
ship between house prices and sea level rise (SLR). They find that houses that are
exposed to sea level rise sell for a discount compared with observably equivalent un-
exposed properties. The authors are able to control for the distance from the beach,
which allows them to alleviate some concerns around differential amenity values of
these properties. Quantitatively, properties that will be inundated after one foot of
global average SLR sell at a 14.7% discount, properties inundated with two to three
feet of SLR sell at a 13.8% discount, and properties inundated with six feet of SLR
sell at a discount of 4.4%. Baldauf et al. (2020) present related evidence suggesting
that the extent to which physical climate risk is priced in housing markets depends
on whether the local population believes in climate change. Bakkensen & Barrage
(2017) explore a similar point, highlighting that when individuals who do not believe
in climate change disproportionately sort to purchase more exposed properties, this
will reduce the extent to which climate change risk is priced in housing markets.5
5
Using similar data but a different identification method, based on cross-sectional differences
in relative sea level rise due to vertical land motion, Murfin & Spiegel (2018) find instead a much
smaller effect of climate change exposure on house prices, highlighting the importance of the iden-
22

A related set of papers has explored the effect of hurricanes on house prices,
arguing that a recent hurricane makes future costs of climate change more salient
to individuals, even in cases where the Hurricane did not affect a particular prop-
erty. Ortega & Taspinar (2018) show that following Hurricane Sandy there was a
significant and permanent relative price decline of New York City properties in flood
zones, even if they were not damaged by Sandy. Gibson et al. (2017) also find that
increasing salience of climate risk following hurricanes reduces the relative valuation
of more exposed properties in the New York housing market. Eichholtz et al. (2019)
find similar results in the commercial real estate market. The authors study trans-
actions in three cities, New York, Boston, and Chicago, before and after the shift
in the salience of flood risk caused by Hurricane Sandy. They find that properties
exposed to flood risk experience slower price appreciation after the storm than equiv-
alent unexposed properties. As the previous papers, Eichholtz et al. (2019) conclude
that the price effect is persistent and not driven by physical damage incurred from
Hurricane Sandy.
While rising sea levels are a first-order concern for coastal home owners, they
are not the only channel through which climate change poses a physical risk for
real estate values. Another salient risk of climate change is the increasing danger of
wildfires in many states. For example, Corelogic (2019) found that nearly 776,000
homes with an associated reconstruction cost value of more than $221 billion were at
extreme risk of wildfire damage. Many of the most at-risk properties are in California
MSAs, but properties in Texas and Colorado are also potentially at risk. Garnache
& Guilfoos (2019) explore whether such wildfire risk is priced, and find that the price
of homes drops when these home are designated to be in a wildfire risk zone (see also
McCoy & Walsh, 2018).
Since most residential real estate is purchased with a mortgage, climate risk will
also affect the valuations of these mortgages. Consistent with this, recent research
has shown that realizations of wildfire risk and flooding lead to increased mortgage
default (Issler et al., 2019). Similarly, recent evidence provided by Ouazad & Kahn
(2019) suggests that perceived climate risk affects banks’ decisions to securitize orig-
inated mortgages (see also Keenan & Bradt, 2020). This suggests that the federal
government, through the default-risk guarantees that Fannie Mae and Freddie Mac
provide to agency-insured MBS, may be directly exposed to the effects of climate
risks in real estate markets.
tification assumptions for the conclusions in this branch of research.
23

4 CLIMATE FINANCE: A RESEARCH AGENDA
Climate change will be a first-order issue facing our society for many years to come.
Researchers in financial economics have only recently turned their attention to ex-
ploring the many ways in which climate change will affect financial markets. Much
progress has been made on both modeling the relationship between climate, the econ-
omy, and asset prices as well as on documenting the many ways in which climate
risk is already priced in financial markets. But much work remains to be done.
On the modeling side, advances in computational power will allow researchers to
model the various feedback loops between climate change and the real economy with
increasing sophistication. While the basic economic mechanisms of these models will
be similar to those discussed in this review, such modeling advances will provide new
and improved quantifications of important objects such as the social cost of carbon.
On the empirical side, there is substantial scope for improvements of the mea-
sures of climate risk exposure in different asset classes, and in particular for equity
assets. Over the coming years, increased disclosure by firms — whether mandated
by regulators or demanded by large investors — will provide new opportunities to
measure firms’ exposure to various types of climate risks. In the absence of new
data disclosed directly by firms, more creative use of already existing data — such as
satellite imagery or text from 10-K statements or earnings calls — can be processed
to improve climate risk exposure measures. Similarly, more sophisticated sentiment
analysis can improve our measures of negative climate news, as well as our abil-
ity to separately identify news about physical and transition risk. Taken together,
these improvements will improve our ability to construct increasingly more effective
climate hedge portfolios.
Another important question is to explore the extent to which climate risk, through
its effect on asset prices, may affect financial stability. The answer to this question de-
pends, to a large extent, on the degree of concentration of these risks in the portfolios
of financial institutions and investors. Measuring this concentration is an important
and valuable research agenda. To do this, we require better measures of asset-level
risk exposures, which could then be aggregated to the portfolio level. These numbers
would allow financial institutions to better manage their climate risk exposures, and
regulators to ensure that these risks do not pose a threat to financial stability.
ACKNOWLEDGMENTS
Stroebel acknowledges financial support from NBIM through their grant to the
Volatility and Risk Institute at NYU Stern.
24

References
Alok S, Kumar N, Wermers R. 2020. Do fund managers misestimate climatic disaster
risk. The Review of Financial Studies 33:1146–1183
Arrow K, Cropper M, Gollier C, Groom B, Heal G, et al. 2013. Determining benefits

and costs for future generations. Science 341:349–350
Arrow KJ. 1995. Discounting climate change: Planning for an uncertain future.
Lecture given at Institut d’Economie Industrielle, Universite des Sciences Sociales,
Toulouse 24
Baker M, Bergstresser D, Serafeim G, Wurgler J. 2018. Financing the response to

climate change: The pricing and ownership of us green bonds. Tech. rep., National
Bureau of Economic Research
Bakkensen LA, Barrage L. 2017. Flood risk belief heterogeneity and coastal home
price dynamics: Going under water? Tech. rep., National Bureau of Economic
Research
Baldauf M, Garlappi L, Yannelis C. 2020. Does climate change affect real estate
prices? only if you believe in it. The Review of Financial Studies 33:1256–1295
Bansal R, Kiku D, Ochoa M. 2019. Climate change risk
Bansal R, Ochoa M, Kiku D. 2016. Climate change and growth risks. Tech. rep.,
National Bureau of Economic Research
Barnett M. 2017. Climate change and uncertainty: An asset pricing perspective.

Tech. rep., Working Paper
Barnett M. 2020. Estimated impacts of climate policy risk. Tech. rep., Working Paper
Barnett M, Brock W, Hansen LP. 2020. Pricing uncertainty induced by climate

change. The Review of Financial Studies 33:1024–1066
Barreca A, Clay K, Deschenes O, Greenstone M, Shapiro JS. 2016. Adapting to cli-

mate change: The remarkable decline in the us temperature-mortality relationship
over the twentieth century. Journal of Political Economy 124:105–159
Barro RJ. 2013. Environmental protection, rare disasters, and discount rates. Work-
ing Paper 19258, National Bureau of Economic Research
25

Bernstein A, Gustafson MT, Lewis R. 2019. Disaster on the horizon: The price effect
of sea level rise. Journal of financial economics 134:253–272
Binsbergen Jv, Brandt M, Koijen R. 2012. On the timing and pricing of dividends.
American Economic Review 102:1596–1618
Black F, Scholes M. 1973. The pricing of options and corporate liabilities. Journal
of political economy 81:637–654
Bolton P, Kacperczyk M. 2020. Do investors care about carbon risk? Tech. rep.,
National Bureau of Economic Research
Brock WA, Hansen LP. 2018. Wrestling with uncertainty in climate economic models.
University of Chicago, Becker Friedman Institute for Economics Working Paper
Brohé A, Greenstone M. 2007. The economic impacts of climate change: evidence

from agricultural output and random fluctuations in weather. The American Eco-
nomic Review 97:354–385
Burke M, Emerick K. 2016. Adaptation to climate change: Evidence from us agri-

culture. American Economic Journal: Economic Policy 8:106–40
Choi D, Gao Z, Jiang W. 2020. Attention to global warming. The Review of Financial
Studies 33:1112–1145
Corelogic. 2019. The 2019 wildfire risk report
Crost B, Traeger CP. 2014. Optimal co2 mitigation under damage risk valuation.
Nature Climate Change
Daniel KD, Litterman RB, Wagner G. 2019. Declining co2 price paths. Proceedings
of the National Academy of Sciences 116:20886–20891
Deschênes O, Greenstone M. 2011. Climate change, mortality, and adaptation: Evi-

dence from annual fluctuations in weather in the us. American Economic Journal:
Applied Economics 3:152–185
Desmet K, Rossi-Hansberg E. 2015. On the spatial economic impact of global warm-

ing. Journal of Urban Economics 88:16 – 37
Dietz S, Gollier C, Kessler L. 2018. The climate beta. Journal of Environmental

Economics and Management 87:258–274
26

Eichholtz P, Steiner E, Yönder E. 2019. Where, when, and how do sophisticated
investors respond to flood risk? Available at SSRN 3206257
Ellsberg D. 1961. Risk, ambiguity, and the savage axioms. The quarterly journal of
economics :643–669
Engle RF, Giglio S, Kelly B, Lee H, Stroebel J. 2020. Hedging climate change news.
The Review of Financial Studies 33:1184–1216
Garnache C, Guilfoos T. 2019. A city on fire? effect of salience on risk perceptions.

Tech. rep., working paper
Gibson M, Mullins JT, Hill A. 2017. Climate change, flood risk, and property values:
Evidence from new york city. Tech. rep., Working Paper
Giglio S, Maggiori M, Rao K, Stroebel J, Weber A. 2020. Climate change and long-
run discount rates: Evidence from real estate
Giglio S, Maggiori M, Stroebel J. 2015. Very long-run discount rates. The Quarterly
Journal of Economics 130:1–53
Goldsmith-Pinkham PS, Gustafson M, Lewis R, Schwert M. 2019. Sea level rise and
municipal bond yields. Available at SSRN
Gollier C. 2002. Discounting an uncertain future. Journal of public economics 85:149–

166
Gollier C, Weitzman ML. 2010. How should the distant future be discounted when
discount rates are uncertain? Economics Letters 107:350–353
Golosov M, Hassler J, Krusell P, Tsyvinski A. 2014. Optimal taxes on fossil fuel in

general equilibrium. Econometrica 82:41–88
Hansen LP. 2014. Uncertainty outside and inside economic models. Journal of Po-
litical Economy 122:945–87
Hansen LP, Miao J. 2018. Aversion to ambiguity and model misspecification in dy-
namic stochastic environments. Proceedings of the National Academy of Sciences
115:9163–9168
Hauer ME, Evans JM, Mishra DR. 2016. Millions projected to be at risk from sea-
level rise in the continental united states. Nature Climate Change 6:691–695
27

Heal G, Millner A. 2013. Uncertainty and decision in climate change economics. Tech.
rep., National Bureau of Economic Research
Hong H, Li FW, Xu J. 2019. Climate risks and market efficiency. Journal of Econo-
metrics 208:265–281
Hsu PH, Li K, Tsou CY. 2020. The pollution premium. Available at SSRN 3578215
Huynh T, Xia Y. 2020. Climate change news risk and corporate bond returns. Journal
of Financial and Quantitative Analysis, forthcoming
Ilhan E, Sautner Z, Vilkov G. 2019. Carbon tail risk. Available at SSRN 3204420
Issler P, Stanton R, Vergara-Alert C, Wallace N. 2019. Mortgage markets with

climate-change risk: Evidence from wildfires in california. Available at SSRN
3511843
Johannes M, Lochstoer LA, Mou Y. 2016. Learning about consumption dynamics.

The Journal of finance 71:551–600
Keenan JM, Bradt JT. 2020. Underwaterwriting: from theory to empiricism in re-
gional mortgage markets in the us. Climatic Change :1–25
Kelly DL, Kolstad CD. 1999. Bayesian learning, growth, and pollution. Journal of
economic dynamics and control 23:491–518
Kolstad CD. 1992. Looking vs. leaping: the timing of co2 control in the face of
uncertainty and learning. Kaya et al 231
Krueger P, Sautner Z, Starks LT. 2020. The importance of climate risks for institu-
tional investors. The Review of Financial Studies 33:1067–1111
Kurlat P, Stroebel J. 2015. Testing for information asymmetries in real estate mar-
kets. The Review of Financial Studies 28:2429–2461
Lemoine D. 2015. The climate risk premium. Available at SSRN 2560031
Lemoine D. 2020. The climate risk premium: how uncertainty affects the social cost
of carbon. University of Arizona Department of Economics Working Paper :15–01
Lemoine DM, Traeger CP. 2012. Tipping points and ambiguity in the economics of
climate change. Tech. rep., National Bureau of Economic Research
28

Li Q, Shan H, Tang Y, Yao V. 2020. Corporate climate risk: Measurements and
responses. Available at SSRN 3508497
Litterman R, Anderson CE, Bullard N, Caldecott B, Cheung ML, et al. 2020. Man-
aging climate risk in the us financial system
Manne AS, Manne AS, Richels RG, Richels RG. 1992. Buying greenhouse insurance:
the economic costs of carbon dioxide emission limits. MIT press
McCoy SJ, Walsh RP. 2018. Wildfire risk, salience & housing demand. Journal of
Environmental Economics and Management 91:203–228
Merton RC. 1973. Theory of rational option pricing. The Bell Journal of economics
and management science :141–183
Murfin J, Spiegel M. 2018. Is the risk of sea level rise capitalized in residential real
estate. Working paper
Nordhaus WD. 1977. Economic growth and climate: the carbon dioxide problem.
The American Economic Review 67:341–346
Nordhaus WD. 1991. To slow or not to slow: the economics of the greenhouse effect.
The economic journal 101:920–937
Nordhaus WD. 1992. An optimal transition path for controlling greenhouse gases.
Science 258:1315–1319
Nordhaus WD. 1994. Managing the global commons: the economics of climate
change, vol. 31. MIT press Cambridge, MA
Nordhaus WD. 2007. A review of the stern review on the economics of climate change.
Journal of Economic Literature 45:686–702
Nordhaus WD. 2008. A question of balance: Weighing the options on global warming
policies. Yale University Press
Nordhaus WD, Boyer J. 2000. Warming the world: Economic models of global warm-
ing. MIT press
Nordhaus WD, Popp D. 1997. What is the value of scientific knowledge? an appli-
cation to global warming using the price model. The Energy Journal 18
29

Ortega F, Taspinar S. 2018. Rising sea levels and sinking property values: Hurricane
sandy and new york’s housing market. Journal of Urban Economics 106:81–100
Ouazad A, Kahn ME. 2019. Mortgage finance in the face of rising climate risk. Tech.
rep., National Bureau of Economic Research
Painter M. 2020. An inconvenient cost: The effects of climate change on municipal

bonds. Journal of Financial Economics 135:468–482
Pedersen LH, Fitzgibbons S, Pomorski L. forthcoming. Responsible investing: The

esg-efficient frontier. Journal of Financial Economics
Pérez-González F, Yun H. 2013. Risk management and firm value: Evidence from
weather derivatives. The Journal of Finance 68:2143–2176
Piazzesi M, Schneider M, Stroebel J. 2020. Segmented housing search. American

Economic Review 110:720–59
Rao K. 2017. Climate change and housing: Will a rising tide sink all homes? Zillow
Research
Sautner Z, van Lent L, Vilkov G, Zhang R. 2020. Firm-level climate change exposure.
Available at SSRN 3642508
Stern N. 2007. The economics of climate change: the stern report. Cambridge, UK
Traeger CP. 2013. Discounting under uncertainty: Disentangling the weitzman and
the gollier effect. Journal of Environmental Economics and Management 66:573 –
582
van Binsbergen J, Hueskes W, Koijen R, Vrugt E. 2013. Equity yields. Journal of

Financial Economics 110:503 – 519
Van Binsbergen JH, Koijen RS. 2017. The term structure of returns: Facts and
theory. Journal of Financial Economics 124:1–21
Wagner G, Weitzman ML. 2015. Climate shock: The economic consequences of a

hotter planet. Princeton, NJ: Princeton University Press
Weitzman ML. 2001. Gamma discounting. American Economic Review 91:260–271
Weitzman ML. 2007. A review of the stern review on the economics of climate change.
Journal of Economic Literature 45:703–724
30

Weitzman ML. 2009. On modeling and interpreting the economics of catastrophic
climate change. The Review of Economics and Statistics 91:1–19
Weitzman ML. 2012. Rare disasters, tail-hedged investments, and risk-adjusted dis-
count rates. Working Paper 18496, National Bureau of Economic Research
Weitzman ML. 2014. Fat tails and the social cost of carbon. The American Economic
Review 104:544–546
31

SSRN Id3719139

Uploaded by

Copyright:

Available Formats

SSRN Id3719139

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

SSRN Id3719139

Uploaded by

Copyright:

Available Formats

Climate Finance∗

Stefano Giglio1 , Bryan Kelly2 , and Johannes Stroebel3

October 26, 2020

Electronic copy available at: https://ssrn.com/abstract=3719139

Electronic copy available at: https://ssrn.com/abstract=3719139

2 CLIMATE RISK AND ASSET PRICES: THE-

Electronic copy available at: https://ssrn.com/abstract=3719139

∆ct+1 = µ + xt + Jt+1 , (1)

Electronic copy available at: https://ssrn.com/abstract=3719139

Uncertainty about the path of climate change. We begin by studying the

Electronic copy available at: https://ssrn.com/abstract=3719139

Asset pricing implications. The discussion above highlights that equations 1–

Electronic copy available at: https://ssrn.com/abstract=3719139

Electronic copy available at: https://ssrn.com/abstract=3719139

Electronic copy available at: https://ssrn.com/abstract=3719139

Electronic copy available at: https://ssrn.com/abstract=3719139

“Uncertainty is fundamental to climate change. Today’s greenhouse gas

Recent climate-economic theory begins to confront ambiguity in climate economic

Electronic copy available at: https://ssrn.com/abstract=3719139

Source: Climate Lab Book (http://www.climate-lab-book.ac.uk/).

models. As an example, Figure 1 shows the divergence in forecasted temperature

Electronic copy available at: https://ssrn.com/abstract=3719139

Electronic copy available at: https://ssrn.com/abstract=3719139

3 CLIMATE RISK AND ASSET MARKETS: EM-

Electronic copy available at: https://ssrn.com/abstract=3719139

3.1 CLIMATE RISK AND FINANCIAL ASSETS

Electronic copy available at: https://ssrn.com/abstract=3719139

Electronic copy available at: https://ssrn.com/abstract=3719139

Electronic copy available at: https://ssrn.com/abstract=3719139

Electronic copy available at: https://ssrn.com/abstract=3719139

225 2009 Copenhagen

UNFCCC 4th IPCC Report Agreement

Source: Engle et al. (2020).

Electronic copy available at: https://ssrn.com/abstract=3719139

3.2 CLIMATE RISK AND HOUSING AND MORTGAGE

Electronic copy available at: https://ssrn.com/abstract=3719139

Electronic copy available at: https://ssrn.com/abstract=3719139

Electronic copy available at: https://ssrn.com/abstract=3719139

Electronic copy available at: https://ssrn.com/abstract=3719139

Electronic copy available at: https://ssrn.com/abstract=3719139

Electronic copy available at: https://ssrn.com/abstract=3719139

Arrow K, Cropper M, Gollier C, Groom B, Heal G, et al. 2013. Determining benefits

Baker M, Bergstresser D, Serafeim G, Wurgler J. 2018. Financing the response to

Bansal R, Kiku D, Ochoa M. 2019. Climate change risk

Barnett M. 2017. Climate change and uncertainty: An asset pricing perspective.

Barnett M, Brock W, Hansen LP. 2020. Pricing uncertainty induced by climate

Barreca A, Clay K, Deschenes O, Greenstone M, Shapiro JS. 2016. Adapting to cli-

Electronic copy available at: https://ssrn.com/abstract=3719139

Brohé A, Greenstone M. 2007. The economic impacts of climate change: evidence

Burke M, Emerick K. 2016. Adaptation to climate change: Evidence from us agri-

Corelogic. 2019. The 2019 wildfire risk report

Deschênes O, Greenstone M. 2011. Climate change, mortality, and adaptation: Evi-

Desmet K, Rossi-Hansberg E. 2015. On the spatial economic impact of global warm-

Dietz S, Gollier C, Kessler L. 2018. The climate beta. Journal of Environmental

Electronic copy available at: https://ssrn.com/abstract=3719139

Garnache C, Guilfoos T. 2019. A city on fire? effect of salience on risk perceptions.

Gollier C. 2002. Discounting an uncertain future. Journal of public economics 85:149–

Golosov M, Hassler J, Krusell P, Tsyvinski A. 2014. Optimal taxes on fossil fuel in