Climate change is no longer a distant environmental concern but an immediate macro-financial force reshaping global economic growth, financial stability, and asset returns. This research distils the insights of an advanced climate-finance model into clear implications for policymakers and investors. The central finding indicates that with rising temperatures, economic growth slows lastingly while financial uncertainty increases. Under a 3°C warming scenario, the equity risk premium (ERP) is projected to rise by c. 15–25%, while real risk-free rates temporarily decline and valuation multiples recede for risky assets.

Unprecedented climate reality calls for a new asset pricing toolkit

Financial markets are forward-looking, with investors basing decisions on expectations about future consumption, productivity, and uncertainty. Traditional risk models often assume stationary economic dynamics and stable growth patterns, assumptions that are broken by rising temperatures and extreme weather. This research utilises a new quantitative framework that connects a physical climate module with a long-run risk macroeconomic model based on the work of Bansal and Yaron (2004). By embedding climate directly into the drivers of consumption growth, the model generates closed-form formulas for core financial quantities, including the risk-free rate, the ERP, and price-dividend ratios.

Why global temperatures matter for asset pricing

Global temperatures affect macroeconomic conditions through three fundamental channels. Firstly, physical damages from persistent temperature increases reduce productivity—particularly outdoor labour—agricultural yields, and manufacturing efficiency. Quantitative studies estimate global GDP losses of 20-30% in moderate warming scenarios and over 40% in high-warming cases. Secondly, transition costs from mitigation policies, such as carbon pricing and clean-energy investments, require economic resources and create near-term headwinds. Thirdly, temperature-driven uncertainty increases volatility in weather-sensitive production. Higher uncertainty raises risk premia, which significantly impacts long-duration assets as markets price climate outcomes long before they materialise.

How to price climate risks? A dual-module framework

The framework consists of two coupled modules. The climate module captures both temperature and policy uncertainties using a double mean-reverting process. It is calibrated to the Network for Greening the Financial System (NGFS) “Current Policies” projections, which anticipate a temperature anomaly of 3°C by 2100. The economic module incorporates physical damages and transition costs into the consumption growth process. Physical damages are modelled as persistent rather than permanent, lasting roughly a decade for each incremental temperature rise. Transition costs arise whenever policy targets deviate from business-as-usual warming, acting as a hindrance to growth when policies become more stringent.

What are the impacts on the financial market?

A primary impact is the sagging of the real risk-free rate. As temperatures rise and climate damage accumulates, expected long-run consumption growth declines. This slowdown translates into a decline in the real risk-free rate, which is particularly pronounced between 2030 and 2050. This effect is transitory; as the system moves toward a more stable state and the economy adapts, the rate gradually converges back to its long-run level. This behaviour has direct implications for sovereign debt sustainability, the choice of discount rates for pension funds, and the pricing of inflation-linked instruments.

Simultaneously, the ERP is projected to rise by 15–25% relative to current levels under a 3°C scenario. This occurs because the risks to consumption—lower growth, higher volatility, and temperature-related shocks—become more significant to investors. The rise in the ERP mechanically implies lower valuation multiples, such as price-dividend and price-earning ratios. The largest impact is expected on assets with long-duration cash flows, including technology and growth equities, infrastructure and utility assets, and issuers in emerging markets highly exposed to physical climate risk.

Structural implications for investors and policymakers

Investors now face a macro-financial regime defined by climate-adjusted expectations. Higher ERP necessitates higher expected returns, which lowers valuations in the near term. Sectors sensitive to policy and energy costs face significant repricing risk on volatile transition pathways, though a rise in climate hedging solutions is also expected from an almost non-existent current state. For policymakers, the findings suggest that financial stability will depend increasingly on the chosen climate pathway. Macroprudential frameworks must incorporate long-horizon climate risks, and stable, credible transition pathways are essential to reduce uncertainty and dampen the rise in risk premia across global markets.