Extreme Weather Risk and the Cost of Equity

Abstract

We examine if extreme weather exposure impacts the cost of equity of U.S. firms. Motivated by a consumption-based asset pricing model with heterogeneous agents, we derive two conditions for a meteorological risk premium in the cross-section of stock returns that can be tested em- pirically. We find that – since the mid 1990s – stocks of domestic firms that reacted negatively to severe storm losses outperformed stocks that reacted positively by at least 6.5% p.a. This risk premium can neither be explained by standard asset pricing factors nor firm characteristics. Our results reveal how climate risk may be linked to firm value.

Keywords: Extreme Weather Risk, Climate Risk, Cost of Equity, Empirical Asset Pricing

JEL Classification: C12, G01, G11, G12, G17