Introduction

Climate change poses systemic risks to health, the economy, and financial systems. Financial economics provides tools to measure, price, and manage climate risk. Climate finance has emerged as a field examining how markets mitigate risks through capital allocation and hedging. Financial markets direct investment towards low-carbon projects, such as green bonds and climate-aware funds, while also providing risk-sharing opportunities across investors and regions.

Climate risk and asset prices: Theory

Two main approaches embed climate risk into macro-finance models. The first focuses on uncertainty about climate disasters, such as tipping points causing sharp declines in consumption and growth. The second links risk to uncertainty about economic activity, where higher growth increases emissions and damages.

These approaches generate different implications for risk premia. In climate disaster models, assets exposed to climate damages require positive risk premia, while mitigation investments offer insurance and are discounted at lower rates. In economic-driven models, mitigation investments are riskier, carrying positive premia and lower valuations.

The term structure of discount rates depends on economic dynamics. If shocks persist, long-term assets are more exposed, increasing absolute discount rates. Evidence from equities and real estate suggests declining premia with horizon, consistent with partial mean reversion after climate shocks.

Preferences, such as Epstein–Zin utility, amplify the impact of long-run risks and support earlier mitigation. Model uncertainty further increases the social cost of carbon. Ambiguity aversion can magnify carbon costs by 60–70% compared with neutral models.

Climate risk and asset markets: Empirical evidence

Climate risks divide into physical risks (e.g., asset impairment from sea level rise) and transition risks (e.g., carbon taxes, technological shifts). Both risks create winners and losers in markets. Investor attention has grown only recently, limiting time-series data but increasingly influencing asset pricing.

Financial assets. Large institutional investors now integrate climate considerations. Survey evidence shows 39% of managers reduce portfolio carbon footprints. In equities, higher carbon emissions are associated with discounts, with one standard deviation increase linked to an additional 2% expected return per annum. Carbon-intensive firms underperform during warm periods, while firms with high environmental scores perform better during negative climate news. Option markets also price higher downside risk for carbon-intensive firms.

In fixed income, municipal bonds from areas exposed to sea level rise show higher yields, especially for long maturities, reflecting discounted cash flows. Corporate bonds with positive covariance to climate news earn lower returns, consistent with risk pricing. Green bonds trade at yields about 6 basis points lower than comparable non-green bonds, reflecting investor preference.

Dynamic hedging strategies can be built using equity portfolios that mimic climate news indices, such as the one derived from Wall Street Journal coverage. Out-of-sample tests show 20–30% correlation with climate news shocks. These portfolios help hedge both long-term climate damages and the arrival of new information.

Housing and mortgage markets. Properties exposed to flooding risk, such as in coastal US states, are discounted when climate risks receive attention. A doubling in climate risk mentions in listings corresponds to a 2.4% relative decline in flood-zone property values. Other studies find discounts up to 14.7% for highly exposed homes. Hurricanes increase salience, leading to persistent price declines even for undamaged properties. Wildfire risk also reduces home values in affected states. Mortgage default rates rise following climate disasters, and lenders adjust securitisation practices, exposing federal agencies to risk.

Climate finance: A research agenda

Future research should refine models linking climate, the economy, and asset prices, using advanced computational methods to quantify the social cost of carbon. Empirical improvements are needed in measuring firm-level exposures, through better disclosure, text analysis, and satellite data. Enhanced sentiment measures could distinguish between physical and transition risks.

Another priority is examining whether climate risks threaten financial stability by concentrating in portfolios of key institutions. Developing asset-level risk measures that can be aggregated will support both risk management and regulatory oversight.