Is there a premium for climate risks?
European Central Bank experts Giovanna Bua, Daniel Kapp, Federico Ramella, and Lavinia Rognone published on this topic a working paper entitled "Transition versus physical climate risk pricing in European financial markets: a text-based approach".
This report assesses the existence of climate risk premia by laying out two physical and transition risk indicators based on text analysis.
The main conclusions include:
- The physical risks indicator spikes during days where the discussion increases substantially. The vocabulary used allows to capture both extreme and chronic physical hazards.
- The transition risk indicator spikes for many important events which determined transition and regulatory action, one of the most important ones being the Paris Agreement.
- Both a physical and transition climate risk premium can be measured, but only since the Paris Agreements. From 2015 onward, stocks which provide a bad hedge against climate risks require a higher return than the others.
- The proposed methodology does not rely on a phraseology defined ex-ante by the authors, but on that extracted from authoritative texts, allowing for a less biased detection.
- Transition risk exposure tends to be measured by the market using firm level information, in particular since 2015.
- In contrast, exposures to physical risk tend to be measured using simple sectoral classifications.
This report contributes to existing literature by providing transition and physical risks indices, but also developing a text-based approach to assess them and study the influence of these risks on asset prices.