Transition Versus Physical Climate Risk Pricing in European Financial Markets

This ECB working paper introduces two new indicators to examine physical and transition climate risk premiums in euro area equity markets. Based on textual analysis, the study finds there have been climate risk premiums since 2015 and investors have required a relatively higher return from stocks which provide a bad hedge against climate risk.

Scientific texts on climate change topics were used to build two distinct vocabularies capturing climate risk characteristics and their interconnections. These were then compared with a collection of over one million Reuters news stories published between 2005 and 2021 to develop both a physical and a transition risk index.

These indices were found to spike during days when coverage of either risk type increased substantially. The transition indicator showed spikes for significant events associated with transition and regulatory action, while the physical risk indicator spiked during discussion of extreme and chronic physical hazards caused by climate change.

Using a standard portfolio sorting approach, the study then employed a time-series regression of firm-level equity returns on the climate risk indices to gauge stock return sensitivities to climate and carbon risk. The results show there have been climate risk premiums since 2015, around the time of the Paris Agreement. Since then, investors seem to have required a relatively higher return from stocks which provide a bad hedge against climate risk.

The methodology can also be applied to other asset classes, the authors say.

“The findings presented in this study, with the most important contribution being the transition and physical risk indices, can be used to inform investors, policy makers and financial institutions alike about the extent to which financial markets price climate risks,” the paper concludes, calling for further research on the link between climate risks and granular firm characteristics.