Climate Change in Financial Markets

Abstract

What is the discount rate on large-scale projects to mitigate climate change? This paper proposes a model that answers this question. In the model, climate change manifests itself through disasters that destroy capital. The probability of those disasters is endogenous and grows with anthropogenic emissions that evolve with new investments in brown capital. I show that large-scale projects or policies aimed at abating climate change should be discounted with a rate significantly lower than the market rate, though this rate is increasing over time. I also outline the additional losses the economy will incur if the policy does not start immediately but instead awaits several years. Finally, I show that only the transition risks rather than the physical risks can explain the green premium and reconcile the theoretical predictions with historical observations.

Keywords: climate change, climate finance, climate risk, physical risk, transition risk, climate disasters, green premium