Asset Diversification versus Climate Action

Abstract

Asset pricing and climate policy are analyzed in a global economy where consumption goods are produced by both a green and a carbon-intensive sector. We allow for two types of damages from global warming. Given that the economy is initially heavily dependent on carbon-intensive capital, the desire to diversify assets complements the attempt to mitigate economic damages from climate change. In the longer run, however, a trade-off between diversification and climate action emerges. We derive the optimal carbon price, the equilibrium risk-free rate, and risk premia. Climate disasters, which are more likely to occur sooner as temperature rises, significantly increase risk premia on financial assets.

Keywords: decarbonization, diversification, carbon price, asset prices, green assets, disaster risk

JEL Classification: D81, G01, G12, Q5, Q54