## Climate Change: Physical Risk and Equity Prices (GLOBAL FINANCIAL STABILITY REPORT Spring 2020, Chapter 5)

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**Canonical URL:** [Climate Change: Physical Risk and Equity Prices (GLOBAL FINANCIAL STABILITY REPORT Spring 2020, Chapter 5)](https://www.imf.org/-/media/files/publications/gfsr/2020/april/english/presentation-ch5.pdf)

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### Overview
- The projected increase in the frequency and severity of disasters due to climatic hazards is a potential threat to financial stability.
- Focus: climate change physical risk and equity markets.
- Sample: 68 economies representing 95 percent of world GDP.
- The chapter examines past disasters (looking backward) and projected future disasters/physical risk (looking forward).

### Methodology — Looking back (measuring equity market impact of large disasters)
- For each climatic disaster in the sample, cumulative average abnormal returns (CAARs) are calculated around the event date.
- Event window: CAARs are relative to 21 trading days before the start day to incorporate any potential anticipation effects of disasters.
- Estimation window: Expected returns are computed based on estimates from a one-factor model (global factor) using data in the one-year period before the event window.
- Illustrative events: U.S. Hurricane Katrina (2005) and Thai Floods (2011) — cumulative market return series around start dates show notable but variable impacts.

### Empirical findings — Past disasters and sector impacts
- Large disasters can have a significant impact on equity markets, but on average their impact has been modest.
- Banking sector: negative impact of large disasters on banking sector equity prices in Advanced Economies (AEs) and EMDEs.
- Non-life insurance sector: negative impact of large disasters on non-life insurance sector in AEs.
- Stocks with the highest sensitivity to temperature earn lower returns than others (Percent, 1998–2018), after controlling for standard risk factors — suggesting mispricing.
- In most countries, stocks with the highest sensitivity to temperature earn lower returns than others.

### Mitigating factors
- Greater insurance penetration cushions the negative impact of large disasters on the market and banks, especially when the impact is large.
- Sovereign financial strength (sovereign rating) also cushions the negative impact of large disasters on the market and banks.
- Figures described as:
  - 1. Mitigating Factor: Nonlife Insurance Penetration (Percent)
  - 2. Mitigating Factor: Sovereign Rating (Percent)

### Looking ahead — Projected changes and investor challenges
- Although the severity of climatic hazards is projected to increase, large uncertainty remains.
- Latest Projected Changes in Extreme Weather Events, Relative to 1985–2005 (Various horizons) are shown for:
  - Dangerous heat days per year (2020–39, 2040–59, 2060–79, 2080–99)
  - Extreme precipitation days per year (right scale)
  - Annual heat wave likelihood (2020–39, 2040–59, 2060–79, 2080–99)
  - Annual drought likelihood (2020–39, 2040–59, 2060–79, 2080–99)
- Investors need to form views on:
  - the likelihood of various climate scenarios and their implications for physical risk;
  - the future location of production sites, supply chains, and distribution of customers;
  - the time horizon over which climate change physical risk unfolds, which may be longer than investors’ investment horizon.
- Three analytical approaches used to assess whether climate change physical risk is reflected in equity prices:
  - Cross-sectional asset pricing tests
  - Equity investor attention to temperature
  - Asset pricing model with climate change (Online Box 2)

### Empirical findings — Pricing of future physical risk
- There is no association between predicted changes in climatic hazard occurrence and equity valuations, even when controlling for fundamentals.
- Sign of coefficients from regressions of Price-to-Earnings Ratio on indicators of predicted changes in climatic hazard occurrence:
  - RCP 2.6 / RCP 4.5 / RCP 6.0 / RCP 8.5
    - Δ Extreme Heat Exposure ++++
    - Δ Extreme Precipitations ++++
    - Δ Drought Likelihood ----
    - Δ Heat Wave Likelihood ++++
    - Sea Level Rise Index +
    - Climate Change Hazard Index +
  - Sign consistent with the pricing of climate change physical risk but the coefficient is not statistically significant.
- Conclusion: Climate change physical risk does not appear to be reflected in global equity valuations.

### Main conclusions
- The average impact of large climatic disasters on equity prices has been modest in the past.
- Climate change physical risk does not appear to be reflected in global equity valuations.
- Beyond climate change mitigation and adaptation, sovereign financial strength and higher insurance penetration help to preserve financial stability.

### Policy recommendations
- Enhance insurance penetration and strengthen sovereign financial health.
- Require granular, firm-specific disclosure on current and future exposure and vulnerability to climate change physical risk.
- For financial firms, stress testing can play an important role.
- Climate change mitigation and adaptation policies are of first order importance even beyond the realm of financial stability.

*Source: presentation-ch5*

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