Projecting stock market impacts of climate change via rational bubble models.

Abstract

In this paper, we develop a rational bubble model to quantify the susceptibility of global stock markets to future temperature rises. The approach builds on existing theory incorporating the unpredictable timing of future Black-Swan events alongside price risks that increase in line with global temperature. An alternative specification where climate-change risks are instead linked to atmospheric carbon dioxide levels is also given. The approach offers simplicity, transparency and allows national-level effects to be estimated. In the short term, prices are artificially inflated and volatility artificially deflated as temperatures rise. This is in-line with previous work suggesting carbon-related risks are underpriced by markets. We use our model to estimate stock market exposure to future climate-change risks given future global temperature rises and increases in atmospheric $C{O}_2$ . The potential effects are considerable once global temperatures increases beyond $2^{\circ }C$ above preindustrial levels. We find that climate-change risks are priced in by certain G7 stock markets but not in smaller markets. Estimates of stock market losses directly attributable to global temperature rises up to $2^{\circ }C$ above preindustrial levels are also given.