Finance and climate change: assessing the impact of physical, transition, and regulation risks on asset pricing valuation

Abstract

This study examines how exposure to climate risk, encompassing physical, transition, and regulation risks, affects stock returns. Our main contribution is the insight that stocks with positive temperature co-variation earn lower future returns, acting as a hedge during periods of heightened investor marginal utility. Additionally, a positive change in a firm’s environmental score is associated with higher stock returns, while a higher level of environmental score corresponds to lower stock returns. To evaluate the contribution of climate change factors in the asset pricing model, we construct climate change factor-mimicking portfolios. Empirical results demonstrate that the model, comprising the temperature anomaly factor, climate news factor, and corporate environment factor, consistently outperforms the Fama–French 5-factor and q-factor models in capturing cross-sectional variations in average stock returns. In addition, this model performs better than the model presented by Görgen et al. (2020) and Ume (2021), which incorporate only the carbon risk factor. This underscores the importance of considering multiple facets of climate change in assessing its impact on asset pricing. As a result of this, study, relying solely on one aspect of climate change, may lead to an understatement of its overall effect on financial markets. Implications of this study suggest that considering a multi-faceted approach to climate risk in asset pricing models can lead to more accurate valuation and risk management strategies in financial markets.