Climate Finance: What Is the Impact of Climate Change on Asset Prices?

• Applicant: Professor Dr. Holger Kraft
• Subject Area: Accounting and Finance
• Term: from 2018 to 2022
• Project identifier: Deutsche Forschungsgemeinschaft (DFG) - Project number 416567127

The impact of higher temperatures on the real economy can potentially be disastrous and has intensively been analyzed in so-called integrated assessment models (IAMs). So far, however, there is little research studying the impact of climate change on financial markets. The existing literature in this area does not attempt to simultaneously explain the relevant stylized facts in asset pricing (e.g., high equity premium, low risk-free rate, counter-cyclical Sharpe ratio) and the inaction of mankind when it comes to dealing with climate change (e.g., the issues with implementing the Paris agreement and the unwillingness of some world leaders to accept it). If a model cannot rationalize both issues at the same time, it is questionable whether meaningful predictions about the effect of climate change on asset prices can be made. A potential impact of climate change on asset prices can however be devastating since modern economies are highly reliable on well functioning asset markets. Our project intends to fill this gap. We plan to build a framework where inaction with respect to climate change can be a rational outcome resulting from coordination problems. At the same time we will be able to explain major stylized facts of the asset pricing literature. The starting point of our research is a long-run risk model where the representative agent can control its carbon dioxide emissions at some costs. The representative agent plays the role of a central planner who globally decides upon which abatement actions are to be implemented. This model serves as a benchmark where coordination problems are disregarded. In reality, there are however severe problems of this kind. An example is the current situation where some world leaders threaten to leave the Paris agreement. Therefore, it is crucial to explicitly model these coordination problems that can occur within a country (e.g., households vs. firms) or across countries (e.g., rich vs. poor countries). These problems make it very hard in practice to implement stringent policies against climate change. Consequently, we want to develop and solve tractable models involving endogenous climate change where several agents can actively take actions against global warming. Since every agent benefits from the actions of all other agents, there are potentially severe free-rider problems. Our models shall be able to explain weak climate policies, but also rationalize observed asset prices. We will also be able to make predictions about the influence of climate change on asset prices and conjecture what happens to real interest rates and equity returns if mankind implements more or less stringent policies against climate change. Taking into account the heterogeneous distribution of climate effects across countries, the potential implications can then be studied for different countries that are more or less affected by higher temperatures.

• DFG Programme: Research Grants