The Impact of Physical Climate Risk on the Valuation of Global Equity Assets

How much of climate change is already inside global equity prices?

Riccardo Rebonato, Dherminder Kainth and Lionel Melin estimate what physical climate damage does to the value of a global equity index in "The Impact of Physical Climate Risk on the Valuation of Global Equity Assets".

They work from an enriched version of the DICE integrated assessment model, treat equity as a claim on leveraged aggregate consumption, and discount it with a state-dependent discount factor.

Their main conclusions include:

• Compared to a world without climate damage, the valuation gap runs from under 10% where abatement is prompt and robust to more than 40% where action stays close to business as usual.
• The gap passes 50% under slow abatement while a strong one still holds near 10% when introducing a tipping point taking hold near 2.5 degrees and removing up to 30% of output.
• The aggressive path implies an average temperature anomaly of about 2 degrees by 2100, just inside the Paris range. The slowest one best tracks the decarbonisation of the past twenty years.
• Discounting does much of the work: damages cut consumption, consumption growth and the discount rate, so valuation becomes a tug of war between weaker cashflows and a higher discount factor.
• The correlation between Treasury and S&P 500 returns turned positive again after 2021, which suggests rate relief is available only while inflation stays contained.
• The headline figures are the conservative end. With leverage at the upper end of published estimates, the reduction in equity value is 1.5 to 2 times larger.

This paper shows prices integrate transition risks, but barely any physical ones. Today's valuations are consistent with only two beliefs: very strong abatement or negligible damage to output.

It also finds modelling convention choices in the DCF model decide much of the valuation effect, and a fixed discount rate is not the conservative assumption it looks like.

The model uses a time-separable utility function, which forces risk aversion and the elasticity of substitution to be reciprocal and leaves the risk premium poorly captured.

Damages also hit output alone, not capital or productivity, and the tipping point is treated simply, with agents who already know where the threshold sits.