Climate Change Risk

We argue that if rising temperature has a long-run impact on the aggregate economy (i.e., it increases future volatility, tail risk, etc.), it should be reflected in current equity prices and short-run risk-return tradeoff. Our empirical work shows that this is indeed the case — the long-run temperature elasticity of equity valuations is significantly negative and long-run temperature fluctuations carry a positive risk premium in equity markets. We also find that the temperature risk premium is gradually rising along with the level of temperature. We use our theoretical framework and capital-market estimates to provide a semi-parametric estimate of the social cost of carbon (SCC) emissions. Our evidence suggests a large SCC that is rising with temperature. Overall, our analysis shows that temperature is a source of long-run economic risks and underscores the importance of forward-looking capital markets for understanding the impact and cost of climate change.