## CHAPTER 5 CLIMATE ChANGE: PhYSICAL RISk AND EQUITY PRICES

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### Overview: climate change, hazards, and economic implications
- Global temperatures have increased by 1.1 degrees Celsius relative to preindustrial levels; climate scientists have almost unanimously attributed this change to man-made (anthropogenic) greenhouse gas emissions.
- Based on currently stated mitigation policies, future anthropogenic greenhouse gas emissions are predicted to lead to warming of about 3 degrees Celsius by the end of the century (IPCC 2018).
- Warming at this level is expected to:
  - Adversely impact the world’s stock of natural assets.
  - Lead to a significant rise in sea level.
  - Increase the frequency and severity of extreme weather events (IPCC 2014 and Online Annex Table 5.1.3).
- Impacts are model-uncertain, vary across economies, and may be nonlinear due to climate-system thresholds (DeFries and others 2019).

### Channels by which physical risk affects financial stability
- Channel 1 — Current climatic disasters:
  - Disasters cause loss of life and capital stock and disrupt economic activity, generating physical risk for households, nonfinancial firms, and governments.
  - Financial sector exposures:
    - Insurers: underwriting concentrates impact on insurance sector; reinsurers can absorb portions of risk.
    - Banks: lending activity exposes banks to credit risk.
    - All financial firms: portfolio holdings expose them to market risk; operational and liquidity risks may arise if structures, systems, or deposits are affected.
  - Governments cushion through relief, support, and implicit or explicit insurance, potentially straining government balance sheets and the sovereign–bank nexus.
- Channel 2 — Future climatic disasters (expectations and pricing):
  - Investors form beliefs about future physical risk and insurance coverage; asset-pricing theory implies a premium for assets exposed to future increases in physical risk, lowering prices for exposed assets.
  - Correct pricing is challenging because risk is long-term, complex, and model-dependent; mispricing could cause capital misallocation and economic inefficiency.
  - Sudden shifts in investor perception of future physical risk could cause abrupt drops in asset values and propagate through financial institutions’ balance sheets.

### Data, scope, and analytical focus
- Focus: equity markets (aggregate, bank, and insurance equity prices) as high-frequency signals of investor perceptions and as perpetual claims that should reflect long-term risks.
- Sample and coverage:
  - 68 economies (about 95 percent of world GDP in 2018): 34 advanced and 34 emerging market and developing economies.
  - Sample covers the past 50 years.
- Key analytical questions:
  1. Trends in frequency and severity of climatic disasters.
  2. Historical reactions of aggregate, bank, and insurance equity prices to large climatic disasters.
  3. Whether insurance coverage and sovereign financial strength enhance resilience.
  4. Whether equity valuations as of 2019 correlate negatively with predicted changes in physical risk.
  5. Whether equity investors pay attention to temperature.

### Main findings (chapter summary)
- Climate change is a source of financial risk that could threaten financial stability.
- Historical equity-price reactions to large climatic disasters have generally been modest, especially in economies with:
  - High rates of insurance penetration.
  - Sovereign financial strength.
- Pricing future climate risks is extremely challenging given large uncertainties.
- Current economy-level equity valuations as of 2019 are generally not statistically significantly associated with available proxies of future changes in physical risk.
- Equity investors do not seem to have paid full attention to temperature; this may indicate insufficient attention to climate change risk more broadly.
- Policy implications emphasized:
  - Preserve or enhance sovereign financial strength.
  - Reduce barriers to non–life insurance penetration while ensuring adequate capital in the insurance sector.
  - Encourage adaptation to reduce exposure and vulnerability.
  - Improve measurement and increase disclosure of exposure and vulnerability to climatic hazards to reduce informational challenges and facilitate risk pricing.
- Caveat: preserving or enhancing financial strength may be challenging as public debt ratios continue to increase (see Chapter 1).

### Stylized facts on climatic disasters (sample-level evidence)
- Disaster sample:
  - More than 6,000 disasters in the sample, about 60 percent occurring in emerging market and developing economies.
  - Annual number of disasters rose from slightly more than 50 in the early 1980s to about 200 since 2000; stable over the past 20 years.
  - Floods and storms account for about 80 percent of climatic disasters in the sample.
- Damage relative to GDP and distribution:
  - Emerging market and developing economies: average damage 0.13 percent of GDP.
  - Advanced economies: average damage 0.07 percent of GDP.
  - For the 10 largest disasters (1970–2018):
    - Emerging market and developing economies: damages in the range of 2.9 percent of GDP to 10.1 percent of GDP.
    - Advanced economies: damages in the range of 1.0 percent of GDP to 3.2 percent of GDP.
  - Distribution is asymmetric and strongly positively skewed:
    - Median disaster damage: 0.01 percent of GDP.
    - 95th percentile: about 0.5 percent of GDP.
  - Despite increases in hazard strength and exposure, average damage relative to GDP has not increased much over time—consistent with reductions in vulnerability.
- Aggregate absolute damages:
  - Total annual average damage (constant 2018 US dollars) rose nearly sixfold: surpassing $120 billion in 2010–18 compared with $22 billion in 1980–89.
  - As a share of world GDP, total annual damages have remained broadly constant at about 0.2 percent over the past 30 years.

### Large climatic disasters and equity returns (event-study evidence)
- Macroeconomic impact:
  - Large disasters can significantly adversely impact GDP for several quarters, especially in low-income countries.
- Equity market response:
  - Cumulative average abnormal returns (actual returns minus returns predicted by a pricing model with a global stock market factor, averaged over disasters) are about −1 percent from 21 trading days before the disaster to 40 trading days after the disaster.
  - Results vary considerably across disasters and firms/sectors; some firms or sectors may benefit (for example, construction), while others suffer.

### Impact of large disasters—case illustrations and sector effects
- Case illustrations:
  - US Hurricane Katrina, 2005: damage about 1 percent of US GDP; nearly 2,000 lives lost; half a million people affected; modest reaction with no discernible drop in the US stock market index.
  - Thai floods, 2011: damage amounting to 10.1 percent of GDP; 813 deaths; 9.5 million affected people; Thai stock market drop >8 percent soon after onset; cumulative drop about 30 percent after 40 trading days.
- Sectoral effects:
  - Non–life insurers in advanced economies: cumulative average abnormal returns trend down for about 50 trading days after a large disaster and reach a trough of about −2 percent.
  - Non–life insurers in emerging market and developing economies: no significant reaction.
  - Banks (advanced and emerging market and developing economies): small negative contemporaneous reaction; cumulative average abnormal returns reach a trough of about −1.5 percent 25 trading days after disaster onset.
- Reinsurance and cross-border effects:
  - Global reinsurance companies’ stocks react negatively to disasters in both advanced and emerging market and developing economies.
  - Disasters can affect foreign firms through supply-chain linkages.

### Role of insurance penetration and sovereign financial strength
- Conceptual point: risk-sharing mechanisms (insurance, weather derivatives, catastrophe bonds) reduce firms’ losses in disasters and can limit equity price impacts.
- Observed variation:
  - Non–life insurance penetration (ratio of non–life insurance premiums to GDP) ranges from 0 to 5 across economies.
  - Protection gap is large; even in advanced economies only two-thirds of losses related to climate disasters are covered by insurance.
- Econometric cushioning effects (measured on cumulative abnormal returns 40 trading days after disaster onset, relative to 20 trading days before):
  - Insurance penetration:
    - A 1 percentage point increase in non–life insurance penetration improves banking and industrial sector returns by about 1.5 percentage points on average.
    - In the left tail (when returns are particularly low), the improvement is about 3–4 percentage points.
  - Sovereign financial strength (proxied by sovereign credit rating on a scale of 1 to 21):
    - A one-notch improvement in sovereign rating boosts aggregate market returns by 0.2 percentage point on average.
    - Banking and industrial sector returns increase by 0.3 percentage point on average.
    - When returns are low (left tail), the improvement is about 0.6–1.0 percentage point for the aggregate market and the banking and industrial sectors, and 1.6 percentage points for the non–life insurance sector.
- Interaction: correlation between insurance penetration and sovereign financial strength is high; when jointly considered, sovereign financial strength’s effect appears more robust.
- Policy-relevant implication: insurance coverage and sovereign financial strength are key to maintaining financial stability against climatic disasters.

### Equity pricing of future climate change physical risk
- Investor attention and limits:
  - Market participants have started to focus more on physical risk, but only a very small proportion of global stocks are held by sustainable funds.
  - A 2018 survey: short- and medium-term investors tended to view physical risk as lacking financial materiality; investors with a larger share of sustainable funds ranked climate risk higher for performance relevance.
  - Informational challenges for pricing anticipated increases in physical risk include forming views on climate scenarios, firm-level production and supply-chain locations, and geographic distribution of customers over long horizons—often beyond typical investor horizons.
- Empirical and market-price limitations:
  - Time-varying measures of future physical risk are scarce; firm disclosures on present and future exposure are limited.
  - Catastrophe bonds have maximum maturity of five years; insurance contracts rarely span multiple years—limiting observable market prices for long-horizon physical risk.
- Modeling and scenario analysis:
  - A stylized asset-pricing model suggests:
    - Market-implied equity risk premiums observed in 2019 are in line with those obtained in a scenario with no further warming.
    - Premiums in a no-further-warming scenario are significantly smaller than those obtained under a high-warming scenario—implying equity valuations should be lower if the high-warming scenario materializes.
- Cross-country econometric test using available projections:
  - Projections used: economy-specific hazard occurrence changes between 1986–2005 and 2020–39 from the World Bank Climate Change Knowledge Portal for extreme heat days, drought likelihood, heat wave likelihood, and extreme precipitation days, available under RCP 2.6, RCP 4.5, RCP 6.0, RCP 8.5; also used projected sea level rise by 2100 and a Climate Change Hazard Index (current and future under RCP 8.5).
  - Finding: Overall, no evidence that equity valuations in 2019 were negatively associated with projected changes in hazard occurrence.
    - Simple scatter between Climate Change Hazard Index and price-to-earnings ratios shows no negative association.
    - Econometric analysis: association is positive across five of six hazard measures (the opposite of expected pricing), irrespective of climate scenario.
    - Association is negative only for change in drought likelihood but is not statistically significant.
    - Results are similar when valuations are measured by price-to-book ratios or dividend yields.
  - Caveat: predicted changes in hazard occurrence alone may be misleading because physical risk depends on hazard, exposure, and vulnerability; analysis supplements hazard projections with Climate Change Sensitivity Index and Climate Change Physical Risk Index.

### Temperature-sensitivity anomaly and investor attention
- Method and scope:
  - Extends Kumar, Xin, and Zhang (2019) to 27 economies over 1998–2017.
  - A firm’s temperature sensitivity: absolute value of the “temperature beta,” measured over rolling 60-month windows; temperature anomaly is the difference between the temperature in a given month and the average temperature over the preceding 30 years in the same month.
  - Analysis uses the Fama-French three-factor model; evaluates abnormal returns of portfolios of high-temperature-sensitivity firms controlling for standard risk factors.
- Key empirical result:
  - In 10 of the economies, a portfolio composed of the top 20 percent of stocks most sensitive to temperature underperformed by at least 0.5 percent a month, on average, over the sample period, controlling for standard risk factors.
  - Confirms the United States finding and documents a similar temperature-related pricing anomaly in more than half of the economies considered.
- Interpretation: these pricing anomalies indicate many equity investors have not paid sufficient attention to temperature-related variables and may not be paying sufficient attention to climate change risk.

### Evidence in other asset classes, heterogeneity, and sovereign/bond findings
- Municipal and sovereign bond findings:
  - In the United States, counties projected to be adversely affected by rising sea level face higher costs when issuing long-term municipal bonds (Painter 2020).
  - Sovereigns facing a greater projected change in physical risk—at least for some proxies—pay higher spreads for long-term bonds relative to short-term bonds, all else equal (Online Box 5.3).
- Possible reasons for bond–equity differences:
  - Closer geographic match between climatic disasters and sovereign assets/income reduces informational challenges for bond investors relative to listed firms.
  - Investment-horizon differences: long-term government bond investors may discount less and pay more attention to long-term risks than equity investors.
  - Expectation that governments will bear a greater share of future climatic-disaster costs than listed firms.

### Stress testing, FSAP experience, and country examples
- FSAP program:
  - IMF pioneered stress tests in FSAP 20 years ago.
  - Under FSAP, IMF carries out in-depth financial stability assessments for 12–14 economies each year.
  - Over the past decade, one in five FSAPs contained an examination of climatic risks.
- The Bahamas FSAP example:
  - The country was hit by 11 hurricanes with average costs of 4.3 percent of GDP in the 20 years before the FSAP.
  - FSAP analysis showed financial stability effects of hurricanes were nonlinear and dependent on broader macroeconomic context (for example, a US recession combined with a hurricane would significantly amplify macro-financial losses).
  - Three months after the FSAP concluded, The Bahamas was hit by Hurricane Dorian; the financial sector appears to have weathered the hurricane well owing to limited exposures to uninsured assets and adequate reinsurance, but insurance penetration—especially in the residential segment—remains low.

### Policy recommendations and practical measures
- Strengthen insurance markets and close the protection gap:
  - Non–life insurance is a source of financial resilience.
  - For private insurance markets to thrive, a sound legal and regulatory system is essential.
  - Policymakers may consider mandating coverage for climatic disaster risks for some assets (such as those used as loan collateral), subsidizing climatic disaster insurance, or enabling insurer-of-last-resort solutions where agents have difficulty obtaining insurance.
  - Increase financial and risk literacy to raise awareness of insurance benefits.
  - Address protection-gap challenges via risk-sharing arrangements between public and private sectors, such as Protection Gap Entities.
- Build sovereign financial strength:
  - Build fiscal buffers, establish contingent lines of credit, and develop sound public financial management systems.
  - State contingent debt instruments can allow for greater policy flexibility in bad times.
- Improve climate change literacy and disclosure:
  - Strengthen visibility of findings in climate science, climate economics, and climate finance.
  - Increase granular, firm-specific information on current and future exposure and vulnerability to physical risk to help lenders, insurers, and investors.
  - Encourage voluntary disclosure in line with Taskforce on Climate-related Financial Disclosures (TCFD) recommendations; consider developing global mandatory disclosures on material climate change risks.
  - Short term: mandatory disclosure based on globally agreed principles.
  - Longer term: incorporate climate change risk disclosure standards into financial statements compliant with International Financial Reporting Standards.
- Measurement, taxonomies, and stress testing:
  - Anchor standards and disclosures in proper measurement of financial exposure to climate risk and adequate taxonomies.
  - For financial firms, climate change stress testing and scenario analysis can provide a better sense of exposure sizes at granular levels.
- Adaptation, risk reduction, and mitigation:
  - Adopt adaptation and risk reduction measures: enhancement of early warning systems, management of population density in at-risk areas, land-use regulation, investment in resilient infrastructure, and "build back better" programs.
  - A recent report finds that a global $1.8 trillion investment in adaptation measures over the next decade could generate $7.1 trillion in total net benefits (Global Commission on Adaptation 2019).
  - From a financial stability perspective, manage the transition to a lower-carbon economy carefully to avoid abrupt and unanticipated repricing of portfolios and economic dislocation; gradual but ambitious, clear, and predictable mitigation policies are beneficial.

*Source — ch5 - CHAPTER 5 CLIMATE ChANGE: PhYSICAL RISk AND EQUITY PRICES (PDF).*

### Introduction

### Chapter 5 — Introduction

### Overview: climate change, hazards, and economic implications
- Global temperatures have increased by 1.1 degrees Celsius relative to preindustrial levels, and climate scientists have almost unanimously attributed this change to man-made (anthropogenic) greenhouse gas emissions.
- Based on currently stated mitigation policies, future anthropogenic greenhouse gas emissions are predicted to lead to warming of about 3 degrees Celsius by the end of the century (IPCC 2018).
- Climate change induced by this level of warming is expected to adversely impact the world’s stock of natural assets, lead to a significant rise in sea level, and increase the frequency and severity of extreme weather events (IPCC 2014 and Online Annex Table 5.1.3).
- The impact is subject to a significant degree of model uncertainty, is likely to vary considerably across economies, and may be nonlinear as a result of thresholds in the climate system beyond which the effects accelerate or become irreversible (DeFries and others 2019).

### Two channels by which physical risk affects financial stability
- Channel 1 — Current climatic disasters:
  - Climatic hazards can turn into disasters when exposure is large and vulnerability is high.
  - Disasters cause loss of life and capital stock and disrupt economic activity, generating physical risk for households, nonfinancial firms, and governments.
  - Financial sector exposure:
    - Insurers: underwriting activity concentrates impact on insurance sector and reduces impact on other agents; reinsurers can absorb portions of risk.
    - Banks: lending activity exposes them to credit risk.
    - All financial firms: portfolio holdings of affected securities expose them to market risk; operational and liquidity risks may arise if structures, systems, or deposits are affected.
  - Governments play a cushioning role through relief, support, and implicit or explicit insurance, potentially straining government balance sheets and the sovereign–bank nexus.
- Channel 2 — Future climatic disasters (expectations and pricing):
  - Investors form beliefs about physical risk (climatic hazards, exposures, vulnerabilities) and insurance coverage at various horizons.
  - Standard asset pricing implies investors should demand a premium for assets exposed to future increases in physical risk, lowering prices for exposed assets.
  - Long-term, complex, and model-dependent nature of physical risk makes correct pricing challenging; mispricing could cause capital misallocation and economic inefficiency.
  - Sudden shifts in investor perception of future physical risk could cause abrupt drops in asset values and ripple through financial institutions’ balance sheets.

### Data, scope, and key analytical questions
- Focus: equity markets (aggregate, bank, and insurance equity prices) because they:
  - Provide high-frequency signals of investor perceptions across a broad range of firms.
  - As perpetual claims on firms’ cash flows, should reflect long-term risks, including physical risk.
- Sample and coverage:
  - 68 economies with available aggregate stock market data (about 95 percent of world GDP in 2018).
  - 34 advanced and 34 emerging market and developing economies.
  - Sample covers the past 50 years.
- Key questions examined:
  1. What has been the trend in frequency and severity of climatic disasters in these economies?
  2. How have aggregate equity prices, bank equity prices, and insurance equity prices reacted to large climatic disasters in the past?
  3. Can better insurance coverage and sovereign financial strength enhance the resilience of equity markets and financial institutions?
  4. Are climate change physical risks reflected in equity prices—that is, do equity valuations as of 2019 correlate negatively with predicted changes in physical risk?
  5. Are equity investors paying attention to temperature, an observable climate variable?

### Main findings (chapter summary)
- Climate change is a source of financial risk for investors that could lead to adverse consequences for financial stability.
- Over the past several decades, the reactions of aggregate equity prices, bank equity prices, and insurance equity prices to large climatic disasters have generally been modest, particularly in economies with:
  - High rates of insurance penetration.
  - Sovereign financial strength.
- Pricing future climate risks is extremely challenging given large uncertainties in climate science projections and the economic cost of predicted hazards.
- Current economy-level equity valuations as of 2019 are generally not statistically significantly associated with the currently available proxies of future changes in physical risk.
- Equity investors do not seem to have paid full attention to temperature, which could suggest they do not pay full attention to climate change either.
- Policy implications emphasized:
  - Preserve or enhance sovereign financial strength.
  - Reduce barriers to non–life insurance penetration while ensuring adequate capital in the insurance sector.
  - Encourage adaptation to reduce exposure and vulnerability.
  - Improve measurement and increase disclosure of exposure and vulnerability to climatic hazards to reduce informational challenges and facilitate risk pricing.
- Caveat: preserving or enhancing financial strength may be challenging as public debt ratios continue to increase (see Chapter 1).

### Stylized facts on climatic disasters (sample-level evidence)
- Disaster sample:
  - More than 6,000 disasters in the sample, about 60 percent occurring in emerging market and developing economies.
  - The annual number of disasters increased from slightly more than 50 in the early 1980s to about 200 since 2000; it has remained stable over the past 20 years.
  - Floods and storms account for about 80 percent of climatic disasters in the sample.
- Damage relative to GDP and distributional features:
  - Emerging market and developing economies have suffered almost twice as much average damage relative to the size of their economies: 0.13 percent of GDP compared with 0.07 percent of GDP in advanced economies.
  - For the 10 largest disasters over 1970–2018:
    - Emerging market and developing economies: damages in the range of 2.9 percent of GDP to 10.1 percent of GDP.
    - Advanced economies: damages in the range of 1.0 percent of GDP to 3.2 percent of GDP.
  - The distribution of the damage-to-GDP ratio is asymmetric and strongly positively skewed:
    - Median disaster damage: 0.01 percent of GDP.
    - 95th percentile of the distribution: about 0.5 percent of GDP.
  - Despite increases in hazard strength and exposure, average damage from disasters in terms of GDP has not increased much over time, consistent with reductions in vulnerability.
- Aggregate absolute damages:
  - Total annual average damage from climatic disasters (constant 2018 US dollars) rose nearly sixfold, surpassing $120 billion in 2010–18 compared with $22 billion in 1980–89.
  - As a share of world GDP, total annual damages have remained broadly constant at about 0.2 percent over the past 30 years.

### Large climatic disasters and equity returns (event-study evidence)
- Large disasters can significantly adversely impact GDP for several quarters, especially in low-income countries.
- Equity market response:
  - Cumulative average abnormal returns (actual returns minus returns predicted by a pricing model with a global stock market factor, averaged over disasters) are about −1 percent from 21 trading days before the disaster to 40 trading days after the disaster.
  - Results vary considerably across disasters (some past events such as Hurricane Katrina and others produced larger impacts), and firm-level effects can be heterogeneous (some firms or sectors may benefit, such as construction, while others suffer).

*Source: IMF staff, Chapter 5 — Introduction (ch5 - Introduction).*

### CHAPTER 5 CLIMATE ChANGE: PhYSICAL RISk AND EQUITY PRICES

### CHAPTER 5 CLIMATE ChANGE: PhYSICAL RISk AND EQUITY PRICES

### Impact of Large Climatic Disasters on Equity Markets
- Case illustrations:
  - US Hurricane Katrina, 2005: damage about 1 percent of US GDP, nearly 2,000 lives lost, and half a million people affected; triggered only a modest reaction with no discernible drop in the US stock market index.
  - Thai floods, 2011: damage amounting to 10.1 percent of GDP, 813 deaths, and 9.5 million affected people; resulted in a drop in the Thai stock market index of more than 8 percent soon after the onset and a cumulative drop of about 30 percent after 40 trading days.
- Aggregate market effects:
  - The impact of large climatic disasters on aggregate stock prices has been modest in the sample overall.
- Sectoral effects:
  - Non–life insurers in advanced economies: cumulative average abnormal returns trend down for about 50 trading days after a large disaster and reach a trough of about −2 percent.
  - Non–life insurers in emerging market and developing economies: no significant reaction of insurers’ stock prices.
  - Banks (advanced and emerging market and developing economies): small negative contemporaneous stock market reaction; cumulative average abnormal returns reach a trough of about −1.5 percent 25 trading days after disaster onset.
- Reinsurance and cross-border effects:
  - Stocks of global reinsurance companies react negatively to disasters happening in both advanced economies and emerging market and developing economies.
  - Disasters can affect foreign firms through supply-chain linkages.

### Role of Insurance Penetration and Sovereign Financial Strength
- Conceptual point:
  - Risk-sharing mechanisms (insurance, weather derivatives, catastrophe bonds) reduce losses for firms in disasters and can limit equity price impacts.
- Observed variation:
  - Non–life insurance penetration (ratio of non–life insurance premiums to GDP) ranges from 0 to 5 across economies.
  - Protection gap (share of uninsured losses) for climatic disasters is large; even in advanced economies only two-thirds of losses related to climate disasters are covered by insurance.
- Econometric findings on cushioning effects (impact measured on cumulative abnormal returns 40 trading days after disaster onset, relative to 20 trading days before):
  - Insurance penetration:
    - A 1 percentage point increase in non–life insurance penetration improves banking and industrial sector returns by about 1.5 percentage points on average.
    - In the left tail (when returns are particularly low), the improvement is about 3–4 percentage points.
  - Sovereign financial strength (proxied by sovereign credit rating on a scale of 1 to 21):
    - A one-notch improvement in sovereign rating boosts aggregate market returns by 0.2 percentage point on average.
    - Banking and industrial sector returns increase by 0.3 percentage point on average.
    - When returns are low (left tail), the improvement is about 0.6–1.0 percentage point for the aggregate market and the banking and industrial sectors, and 1.6 percentage points for the non–life insurance sector.
- Interaction:
  - The correlation between insurance penetration and sovereign financial strength is high; when considered jointly, sovereign financial strength’s effect appears more robust.
- Policy-relevant implication:
  - Insurance coverage and sovereign financial strength are key factors in maintaining financial stability against climatic disasters; their importance holds regardless of the size of future climatic shocks.

### Equity Pricing of Future Climate Change Physical Risk
- Investor attention and limits:
  - Financial market participants have started to focus more on physical risk as a source of financial vulnerability.
  - Only a very small proportion of global stocks are held by sustainable funds.
  - A 2018 survey found that short- and medium-term investors were more likely to believe physical risk lacked financial materiality, while investors with a larger share of sustainable funds ranked climate risk higher for performance relevance.
  - Investors face informational challenges in pricing anticipated increases in physical risk: they need to form views on climate scenarios, firm-level production and supply-chain locations, and geographic distribution of customers over long horizons—often beyond typical investor horizons.
- Empirical challenges:
  - Standard asset pricing would require a time-varying measure of future physical risk; such measures are scarce, and firm disclosures on present and future exposure to physical risk are limited.
  - Catastrophe bonds have maximum maturity of five years; insurance contracts rarely span multiple years—limiting observable market prices for long-horizon physical risk.
- Modeling and scenario analysis:
  - A stylized asset-pricing model (Online Box 5.2) suggests:
    - Market-implied equity risk premiums observed in 2019 are in line with those obtained in a scenario with no further warming.
    - Premiums in a no-further-warming scenario are significantly smaller than those obtained under a high-warming scenario—implying equity valuations should be lower if the high-warming scenario materializes.
- Cross-country econometric test using available projections:
  - Projections used: economy-specific hazard occurrence changes between 1986–2005 and 2020–39 from the World Bank Climate Change Knowledge Portal for extreme heat days, drought likelihood, heat wave likelihood, and extreme precipitation days, available under four RCP scenarios (RCP 2.6, RCP 4.5, RCP 6.0, RCP 8.5); also used projected sea level rise by 2100 and a Climate Change Hazard Index (current and future under RCP 8.5).
  - Finding: Overall, there is no evidence that equity valuations in 2019 were negatively associated with projected changes in hazard occurrence.
    - Simple scatter between Climate Change Hazard Index and price-to-earnings ratios shows no negative association.
    - Econometric analysis: association is positive across five of six hazard measures (the opposite of what would be expected if hazards were priced into equity valuations), irrespective of climate scenario considered.
    - The association is negative only for change in drought likelihood but is not statistically significant.
  - Note: The analysis controls for mean annual growth rate of earnings per share, standard deviation of annual growth of earnings per share, and the three-month Treasury bill rate; results are similar when valuations are measured by price-to-book ratios or dividend yields.
- Caveat:
  - Predicted changes in hazard occurrence alone may be misleading because physical risk depends on hazard, exposure, and vulnerability. The analysis supplements hazard projections with proxies for exposure and vulnerability (Climate Change Sensitivity Index and Climate Change Physical Risk Index) to assess combined effects.

### Key Statistics and Measures Used
- Disaster impacts and market responses:
  - US Hurricane Katrina (2005): about 1 percent of US GDP; nearly 2,000 lives lost; half a million people affected.
  - Thai floods (2011): 10.1 percent of GDP; 813 deaths; 9.5 million affected people; Thai stock market drop >8 percent soon after onset; cumulative drop about 30 percent after 40 trading days.
  - Non–life insurers in advanced economies: trough ~−2 percent about 50 trading days after disaster onset.
  - Banks: trough ~−1.5 percent about 25 trading days after disaster onset.
- Insurance penetration:
  - Non–life insurance premium-to-GDP ratio ranges from 0 to 5 across economies (2017).
  - Even in advanced economies, only two-thirds of losses related to climate disasters are covered by insurance.
- Estimated effects on cumulative average abnormal returns (40 trading days after disaster onset):
  - +1 percentage point in non–life insurance penetration → banking and industrial returns increase ~1.5 percentage points on average; in left tail ~3–4 percentage points.
  - +1 sovereign rating notch (scale 1 to 21) → aggregate market +0.2 percentage point on average; banking and industrial +0.3 percentage point on average; in left tail aggregate and those sectors +0.6–1.0 percentage point; non–life insurance +1.6 percentage points in left tail.
- Climate projection horizons and scenarios:
  - Hazard change window: differences between 1986–2005 and 2020–39.
  - Emission scenarios: RCP 2.6, RCP 4.5, RCP 6.0, RCP 8.5 (higher RCP number = higher emissions over multiple time horizons).
  - Sea level rise projections by 2100 used; Climate Change Hazard Index under RCP 8.5 used.

_Italic: Source — ch5 - CHAPTER 5 CLIMATE ChANGE: PhYSICAL RISk AND EQUITY PRICES (PDF)._

### 1. Price-to-Earnings Ratio (in logs; y-axis) and Climate Change Hazard

### ch5 - 1. Price-to-Earnings Ratio (in logs; y-axis) and Climate Change Hazard Index (x-axis)

### Empirical findings on equity valuations and climate physical risk
- Panel 1: Index ranges from 0 to 10.
- Panels 2–4: Coefficients from cross-sectional regressions of the price-to-earnings ratio on climate change physical risk indicators, controlling for expected future earnings, the equity risk premium, and interest rates.
- Climate scenario and projection details preserved:
  - Representative Concentration Pathway (RCP) 2.6, RCP 4.5, RCP 6.0, and RCP 8.5 are IPCC emission scenarios; a higher number is associated with a higher level of emissions.
  - Extreme heat exposure, extreme precipitation, drought likelihood, and heat wave likelihood are projections for the horizon 2020–39.
  - The sea level rise index is based on projections for the year 2100 under RCP 8.5.
  - The Climate Change Hazard Index is based on projections up to 2050 under RCP 8.5.
- Main regression outcome:
  - None of the coefficients in panels 2–4 is significant and has a sign consistent with pricing of climate change physical risk.
  - Summary statements from the figure/text:
    - "There is no association between measures of predicted changes in climatic hazard occurrence and equity valuations ..."
    - "A greater projected increase in hazard risk combined with a greater sensitivity to climate change is not associated with lower valuations ..."
    - "... neither is a greater projected increase in hazard risk combined with a lower capacity to adapt to climate change."
    - "... even when controlling for fundamentals."
- Interaction indices:
  - Climate Change Sensitivity Index: higher values expected to amplify adverse effects of climatic hazards (greater physical risk).
  - Climate Change Adaptive Capacity Index: higher values expected to dampen adverse effects (lower physical risk).
  - Expected empirical signatures (if markets priced risk): negative association between valuations and hazard × Sensitivity; positive association between valuations and hazard × Adaptive Capacity. Empirical result: No such associations found.
  - For the Sensitivity Index, the association is generally positive and is not statistically significant when it is negative.
  - For the Adaptive Capacity Index, the association is generally the opposite of what pricing would imply, regardless of climate change scenario.

### Temperature-sensitivity anomaly and investor attention
- Method and scope:
  - Extends Kumar, Xin, and Zhang (2019) to a sample of 27 economies over 1998–2017.
  - A firm’s temperature sensitivity is defined as the absolute value of the “temperature beta,” measured over rolling windows of 60 months; the temperature anomaly is the difference between the temperature in a given month and the average temperature over the preceding 30 years in the same month.
  - Analysis uses the Fama-French three-factor model; abnormal returns of portfolios of high-temperature-sensitivity firms are evaluated controlling for standard risk factors.
- Key empirical result:
  - In 10 of the economies, a portfolio composed of the top 20 percent of stocks most sensitive to temperature underperformed by at least 0.5 percent a month, on average, over the sample period, controlling for standard risk factors.
  - The analysis confirms the United States finding and documents a similar temperature-related pricing anomaly in more than half of the economies considered.
- Interpretation:
  - Presence of such pricing anomalies indicates equity investors in many economies have not paid sufficient attention to temperature-related variables and suggests they may not be paying sufficient attention to climate change risk either.

### Evidence in other asset classes and heterogeneity
- Municipal and sovereign bond findings (summarized):
  - In the United States, counties projected to be adversely affected by rising sea level face higher costs when issuing long-term municipal bonds (Painter 2020).
  - Sovereigns facing a greater projected change in physical risk—at least for some available proxies—pay higher spreads for long-term bonds relative to short-term bonds, all else equal (Online Box 5.3).
- Possible reasons for difference between equity and bond pricing:
  - Closer geographic match between climatic disasters and sovereign assets/income reduces informational challenge for bond investors relative to listed firms.
  - Investors' investment horizon differences: long-term government bond investors may discount less and pay more attention to long-term risks than equity investors.
  - Expectation that governments will bear a greater share of costs of future climatic disasters than listed firms.

### Role of country characteristics in market reaction to disasters
- Historical reaction of equity prices to large climatic disasters over the past 50 years has been modest overall.
- Country characteristics that cushion equity markets:
  - Insurance penetration.
  - Sovereign financial strength.
- Policy implication: financial stability will be better preserved in economies that score well on insurance penetration and sovereign financial strength.

### Key statistics and examples from stress testing and FSAPs
- FSAP program features:
  - IMF pioneered stress tests in FSAP 20 years ago.
  - Every year, under the FSAP, the IMF carries out in-depth financial stability assessments for 12–14 economies.
  - Over the past decade, one in five FSAPs contained an examination of climatic risks.
- The Bahamas FSAP example:
  - The country was hit by 11 hurricanes with average costs of 4.3 percent of GDP in the 20 years before the FSAP.
  - The FSAP analysis showed financial stability effects of hurricanes were nonlinear and dependent on the broader macroeconomic context (for example, a US recession combined with a hurricane would significantly amplify macro-financial losses).
  - Three months after the FSAP concluded, The Bahamas was hit by Hurricane Dorian; the financial sector appears to have weathered the hurricane well owing to limited exposures to uninsured assets and adequate reinsurance, but insurance penetration—especially in the residential segment—remains low.

### Policy recommendations and practical measures
- Strengthen insurance markets and close the protection gap:
  - Non–life insurance is a source of financial resilience.
  - For private insurance markets to thrive, a sound legal and regulatory system is essential.
  - Policymakers may consider mandating coverage for climatic disaster risks for some assets (such as those used as loan collateral), subsidizing climatic disaster insurance, or enabling insurer-of-last-resort solutions where agents have difficulty obtaining insurance.
  - Increase financial and risk literacy to raise awareness of insurance benefits.
  - Address protection-gap challenges via risk-sharing arrangements between public and private sectors, such as Protection Gap Entities.
- Build sovereign financial strength:
  - Build fiscal buffers, establish contingent lines of credit, and develop sound public financial management systems.
  - State contingent debt instruments can allow for greater policy flexibility in bad times.
- Improve climate change literacy and disclosure:
  - Strengthen visibility of findings in climate science, climate economics, and climate finance.
  - Increase granular, firm-specific information on current and future exposure and vulnerability to climate change physical risk to help lenders, insurers, and investors.
  - Encourage voluntary disclosure in line with Taskforce on Climate-related Financial Disclosures (TCFD) recommendations; consider developing global mandatory disclosures on material climate change risks.
  - Short term: mandatory disclosure based on globally agreed principles.
  - Longer term: incorporate climate change risk disclosure standards into financial statements compliant with International Financial Reporting Standards.
- Measurement, taxonomies, and stress testing:
  - Anchor standards and disclosures in proper measurement of financial exposure to climate risk and adequate taxonomies.
  - For financial firms, climate change stress testing and scenario analysis can provide a better sense of exposure sizes at granular levels.
- Adaptation, risk reduction, and mitigation:
  - Adopt adaptation and risk reduction measures to decrease exposures and vulnerabilities, including enhancement of early warning systems, management of population density in at-risk areas, land-use regulation, and investment in resilient infrastructure and "build back better" programs.
  - Note: A recent report finds that a global $1.8 trillion investment in adaptation measures over the next decade could generate $7.1 trillion in total net benefits (Global Commission on Adaptation 2019).
  - From a financial stability perspective, manage the transition to a lower-carbon economy carefully to avoid abrupt and unanticipated repricing of portfolios and economic dislocation; gradual but ambitious, clear, and predictable mitigation policies are beneficial for the transition path.

*Source: IMF staff calculations and text from ch5 - 1. Price-to-Earnings Ratio (in logs; y-axis) and Climate Change Hazard (chapter content).*

### Box 5.1. Stress Testing for Physical Risk in the Financial Sector Assessment Program

### Box 5.1. Stress Testing for Physical Risk in the Financial Sector Assessment Program

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*Source: Box 5.1. Stress Testing for Physical Risk in the Financial Sector Assessment Program (ch5 - Box 5.1. Stress Testing for Physical Risk in the Financial Sector Assessment Program).*

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_Source: https://www.imf.org/-/media/files/publications/gfsr/2020/april/english/ch5.pdf_