Introduction

The report examines how physical and transition climate risks affect asset valuation. Physical risk is defined as GDP loss from climate damages under different abatement policies, while transition risk relates to the costs of moving to a low-carbon economy. The authors argue that treating these risks separately is unhelpful, as there is a strong inverse relationship between them. Transition costs, defined as the diversion of disposable income needed for decarbonisation, are shown to reduce both the expectation and variability of physical damages. The analysis stresses the need to consider expectations and uncertainties together, rather than in isolation.

Definitions and methodology

The study employs the Nordhaus and Sztorc (2013) DICE integrated assessment model, adapted to allow stochastic economic output and uncertainty in climate damages. Abatement costs, which include adaptation and carbon removal, are taken as proxies for transition costs. The model assumes suboptimal, politically driven abatement, reflecting real-world divergence from optimal policies. The effective abatement speed (κ) is introduced as a key measure, linking emissions, GDP and abatement activity. The framework captures how uncertainty in abatement paths and economic conditions translates into variability in damages and transition costs.

The dependence of Ωt on Λt

A clear dependence is established between physical damages (Ωt) and transition costs (Λt). Stronger abatement increases transition costs but reduces physical damages. Under deterministic conditions, this relationship is tight; when uncertainty in economic output and damage functions is introduced, variability rises significantly. The analysis highlights the importance of the damage exponent, which can amplify damages even under fixed abatement paths. Quantitative findings show that higher abatement speeds raise expected transition costs but lower uncertainty around them. For example, when targeting decarbonisation by 2050, abatement cost distributions widen under slower abatement scenarios, while higher abatement speeds concentrate outcomes despite higher expected costs.

Links with the SSP/RCP scenarios

The study links its findings to IPCC SSP/RCP scenarios. Cumulative abatement costs in the model correspond to cumulative carbon taxes in SSP/RCP pathways. For instance, under RCP4.5 (2.6°C), cumulative abatement costs range from 4–11% of GDP, equivalent to a 0.57–1.57% annual tax in 2100. Under RCP2.6 (1.8°C), costs are higher, between 35–55% cumulatively, equivalent to 5–7.9% of GDP in 2100. These align well with SSP/RCP projections. Unlike SSP/RCP, the model provides probability distributions, allowing estimates of likelihood and the correlation between damages and costs. Findings show that under stronger abatement, the correlation between damages and costs increases, enhancing predictability of outcomes.

Investment implications

The report highlights implications for investors, particularly in equity valuation. Discounted cash flow models require estimates of cashflow impairments from climate risks. The framework provides joint distributions of physical damages and transition costs, improving inputs to valuation models. Transition costs are likened to an effective corporate tax, likely to fall on companies rather than consumers. Historical evidence shows corporate taxation has been a significant driver of equity prices, so increased transition costs represent valuation headwinds for global equities. State- and path-dependent results also allow for refined discounting approaches.

Discussion, limitations and conclusions

The report decomposes transition costs into expectations and risk, showing their inverse link with physical damages. Joint analysis of both risks is recommended, as separate treatment obscures important interactions. Transition costs estimated are consistent with SSP/RCP scenarios, but the model adds a probabilistic dimension. The authors note limitations, including reliance on efficient allocation of abatement resources; real-world inefficiencies, such as subsidies, could raise costs. Delayed or rushed transitions would also increase costs. Findings are relevant to policymakers and investors, offering a structured way to assess climate-related impairments to cashflows.