Physical vs. Transition climate risks: Asymmetric effects on stock return predictability

Abstract

This paper examines the predictive role of two dominant climate risk categories – physical and transition risks – in forecasting U.S. equity market risk premiums. The results reveal a pronounced asymmetry: physical climate risk significantly and negatively predicts stock returns both in-sample and out-of-sample, whereas transition climate risk demonstrates insignificant forecasting ability. This superior performance of physical risk delivers greater economic gains to investors and remains robust even after controlling for widely used economic predictors. However, its predictability is state-dependent, weakening during economic disruptions and strengthening following the COP21 Agreement. Further analysis shows that the cash flow and sentiment channels potentially drive the strong predictability of physical risk. Overall, our findings underscore the importance of incorporating physical climate risk into equity return forecasting models, offering actionable insights for financial decision-making processes.