The Impact of Physical Climate Risk on Global Equity Valuations

Abstract

We estimate how the value of a hypothetical global equity index can be affected by physical climate damage for different degrees of aggressiveness of the abatement policy. We find that the magnitude of the difference in equity valuation with respect to a world without climate damages mainly depends i) on the aggressiveness of the abatement policy (the slower the abatement, the greater the difference); ii) on the presence of otherwise of tipping points with relatively low threshold temperatures; and iii) on the extent to which rates will decline in states of low consumption (of economic distress). The difference in equity valuations between a no-climate-damage world and a world with climate damages can be significant, ranging from a few percentage points to over 40\% depending on the abatement policy, the nearness of tipping point, and the magnitude of the discounting effect. This leaves open the question of the extent to which these differences in valuation are already embedded in equity market prices. We argue that current valuations appear to imply either a very strong and effective abatement action, or that climate change will have a negligible effect on economic output. Since neither assumption should be considered a very likely scenario, we conclude that there is ample potential for equity revaluation.

Keywords: Equity valuation, climate change, stochastic discount factir

JEL Classification: G00, Q00