Impact of Physical Climate Risks on Financial Assets

Roshen Fernando

Abstract: Climate change poses substantial risks to global socioeconomic stability. The financial sector of the economy could be affected by climate risks both independent of the real sector and due to the linkages with the real sector. Understanding these linkages is crucial not only to prevent the vulnerability of the financial sector to climate risks but also to effectively utilize the financial markets to raise finance for mitigation and adaptation efforts. This paper explores the impacts of physical climate risks on the risk premia of financial assets. We employ a range of climate indicators representative of chronic and extreme climate risks and a mix of panel regressions, machine learning, and local projections to examine the contemporaneous and persistent effects of physical climate risks on financial assets. We also investigate the exposure of different economic subsectors and assets to physical climate risks. We observe that employing a suite of climate indicators enriches the understanding of the impacts of physical climate risks on financial assets. Most of these pathways align with the impacts on the real sector of the economy via sectoral productivity. The physical climate risks could have persistent effects for several years, both at the aggregate and sectoral levels. Different assets could experience similar effects, although safer assets could reduce the exposure of asset portfolios to climate risks.

Keywords: Climate Change, Financial Markets, Econometrics, Machine Learning, Local Projections