Climate Disasters and Financial Fundamentals
43 Pages Posted: 25 Nov 2019
Date Written: November 13, 2019
I propose a rare disaster model of an economy where disasters are driven by CO2 levels that are determined by inputs of carbons from the firms of the economy. The probability and intensity of disaster are determined in part by the level of CO2 in the environment. In turn, disasters affect the budgets, the labor allocations and investment decisions of households; the production and investment decisions of firms; and, monetary policy. Prices are determined in equilibrium. From this model, Six propositions are developed relating carbon dioxide levels and climatic economic damages to the financial variables: the risk free rate, the price dividend ratio, and the risk premium.
The six propositions are then tested empirically using a unique data set for the United States over the period from March 1958 to December 2018. The data is found to support the six propositions. In general, carbon use, as proxied by the carbon dioxide level, lowers the risk free rate and price dividend ratio, while raising the risk premium. Climatic economic damages raise the risk free rate, while lowering the price dividend ratio and risk premium. However, if the probability of climatic disaster rises sufficiently, these relationships can change. I then briefly discuss some implications of these results.
Keywords: rare disasters, risk premium, risk free rate, price dividend
JEL Classification: G00, G12
Suggested Citation: Suggested Citation