BUSI 606 Week 5 Annotated Bibliography Example

Climate Risk and the Pricing of Financial Assets: An Annotated Bibliography

Topic and Purpose

The Thematic Literature Review will examine whether and how financial markets price the risks that climate change poses to firms, governments and households. These risks take two forms: physical risks from more frequent extreme weather, rising seas and drought, and transition risks from policies, technologies and preferences that shift the economy away from carbon. The twelve sources below cover equity, bond, option and real estate markets and the investors who trade in them.

Annotated Bibliography

Bernstein, A., Gustafson, M. T., & Lewis, R. (2019). Disaster on the horizon: The price effect of sea level rise. Journal of Financial Economics, 134(2), 253-272. https://doi.org/10.1016/j.jfineco.2019.03.013

Bernstein et al. (2019) ask whether housing markets price the risk of future sea level rise. Comparing coastal homes that would be flooded by a given rise in sea level with otherwise similar homes nearby that would not, they find that exposed properties sell at a discount of about seven percent. The discount is driven mainly by sophisticated buyers, such as investors purchasing homes they will not live in, and it is larger in areas where residents are more worried about climate change. The study's chief strength is its careful comparison of nearly identical homes, which isolates exposure to sea level rise from other features of the coast. Its limitation is that it measures prices at one point in time and cannot show whether the discount is large enough to reflect the full risk. The source anchors the review's theme on physical risk, showing that real asset markets price climate exposure but unevenly across types of buyers.

Bolton, P., & Kacperczyk, M. (2021). Do investors care about carbon risk? Journal of Financial Economics, 142(2), 517-549. https://doi.org/10.1016/j.jfineco.2021.05.008

Bolton and Kacperczyk (2021) examine whether U.S. stock prices reflect companies' carbon emissions. Using firm-level data on direct and indirect emissions, they find that stocks of firms with higher total emissions and faster growth in emissions earn higher returns, even after accounting for standard risk factors, which they interpret as a carbon premium that compensates investors for transition risk. They also find that institutional investors underweight firms with high emission intensity in certain industries. The study is influential because it was among the first to link measured emissions to returns on a large scale, though later research has debated whether the premium reflects risk, mismeasured profitability or investor preferences. Emissions data for many firms are estimated rather than reported, which adds measurement error. The authors also find that the premium is not explained by differences in firms' profitability or by sector alone, which strengthens the risk interpretation. The source is central to the review's theme on equity markets and transition risk.

Bolton, P., & Kacperczyk, M. (2023). Global pricing of carbon-transition risk. The Journal of Finance, 78(6), 3677-3754. https://doi.org/10.1111/jofi.13272

Extending their earlier work beyond the United States, Bolton and Kacperczyk (2023) study firms in 77 countries and find a carbon premium across many markets: firms with higher emissions, and especially faster-growing emissions, have higher stock returns. The premium is broad, appearing across industries and regions, and the authors relate its size to country characteristics such as the stringency of climate policy and the structure of the economy. The premium appears to have grown after major policy moments such as the Paris Agreement. The global scope is the study's major contribution, since it shows that the pricing of transition risk is not a peculiarity of U.S. markets. As in the earlier paper, the reliance on emissions data of uneven quality and the debate over interpretation are limitations. The source will support the review's argument that transition risk is priced in global equity markets and will connect the review to the course's coverage of markets across regions.

Engle, R. F., Giglio, S., Kelly, B., Lee, H., & Stroebel, J. (2020). Hedging climate change news. The Review of Financial Studies, 33(3), 1184-1216. https://doi.org/10.1093/rfs/hhz072

Engle et al. (2020) propose a method for investors to hedge the risk of bad news about climate change. They construct an index of climate news from the text of a major newspaper and then build portfolios of stocks, selected using firms' environmental scores, whose returns rise when climate news worsens. The resulting portfolios hedge climate news reasonably well out of sample, offering a practical tool for investors who want protection against climate risk. The approach treats climate risk as something that arrives through news, which allows investors to hedge without forecasting the climate itself. The study is methodologically creative, combining text analysis with portfolio construction, but its hedging performance depends on how well environmental scores capture firms' true exposure, a known weakness of such ratings. The source will be used in the review's theme on investors, illustrating how climate risk can be managed in portfolios and why measurement of exposure remains a challenge.

Flammer, C. (2021). Corporate green bonds. Journal of Financial Economics, 142(2), 499-516. https://doi.org/10.1016/j.jfineco.2021.01.010

Flammer (2021) studies corporate bonds whose proceeds are committed to environmentally friendly projects. She finds that stock prices react positively when companies announce green bonds, particularly first-time issues and bonds certified by independent third parties. After issuance, issuers improve their environmental performance, reducing emissions and receiving higher environmental ratings, and they attract more long-term and environmentally minded investors. Flammer interprets these results as evidence that green bonds credibly signal a commitment to the environment rather than serving as greenwashing. The positive effects are concentrated among bonds with external verification, suggesting that certification is what makes the signal believable to investors. The study's careful matching of issuers with similar non-issuers strengthens its conclusions, though signaling and genuine improvement are hard to fully separate. The source will be central to the review's theme on fixed income markets and will provide a contrast to studies that focus on the pricing, rather than the effects, of green bonds.

Giglio, S., Kelly, B., & Stroebel, J. (2021). Climate finance. Annual Review of Financial Economics, 13, 15-36. https://doi.org/10.1146/annurev-financial-102620-103311

This review article surveys research on the interaction between climate change and financial markets. Giglio et al. (2021) distinguish physical and transition risks, explain how each could affect asset prices and summarize evidence from equities, bonds and real estate. They devote particular attention to the discount rates appropriate for valuing investments that reduce climate damages far in the future, and to the difficulty of measuring firms' exposures. The authors also discuss how much of the evidence depends on unusual events, such as storms or policy announcements, and how difficult it is to separate climate effects from other influences on prices. As a review written by leading researchers in the field, it is authoritative and well organized, though it predates some of the most recent studies. It will serve as the organizing framework for the literature review, supplying the distinction between physical and transition risk and the list of open questions that the review's final section will revisit.

Hong, H., Li, F. W., & Xu, J. (2019). Climate risks and market efficiency. Journal of Econometrics, 208(1), 265-281. https://doi.org/10.1016/j.jeconom.2018.09.015

Hong et al. (2019) test whether stock markets efficiently incorporate a well-documented physical climate risk, drought. Using data on drought trends across countries, they find that trends toward drought predicted declines in the profitability of food companies and, crucially, predicted poor stock returns, which means prices had not fully reflected the risk. The finding suggests that markets underreact to slow-moving climate information, a form of inefficiency. The authors suggest that investors pay too little attention to long-term trends that unfold slowly, in contrast to sudden events that attract coverage. The study's strength is its clear economic channel, from drought to crop yields to food company profits, and its international scope; its limitation is that one industry and one risk may not generalize to other sectors or to transition risks. The source will provide the review's main evidence that some climate risks are underpriced, balancing studies that find a premium for climate exposure.

Ilhan, E., Sautner, Z., & Vilkov, G. (2021). Carbon tail risk. The Review of Financial Studies, 34(3), 1540-1571. https://doi.org/10.1093/rfs/hhaa071

Ilhan et al. (2021) use options prices to study whether investors fear sudden losses at carbon-intensive firms. They find that protection against large stock price declines is more expensive for firms with higher carbon intensity, indicating that options markets price the tail risk of abrupt climate policy changes. The effect is stronger when public attention to climate change is high, consistent with investors updating their fears about policy. In other words, investors appear to pay a premium for insurance against the possibility that climate policy will suddenly reduce the value of carbon-intensive firms. Options data provide a forward-looking view of risk that stock returns alone cannot, which is the study's main contribution. A limitation is that options are traded mainly on larger firms, so the results describe the largest emitters better than smaller ones. The source will extend the review's equity theme to derivatives markets and show that transition risk is perceived as a risk of sudden, not only gradual, change.

Krueger, P., Sautner, Z., & Starks, L. T. (2020). The importance of climate risks for institutional investors. The Review of Financial Studies, 33(3), 1067-1111. https://doi.org/10.1093/rfs/hhz137

Krueger et al. (2020) surveyed institutional investors about how they view and manage climate risks. Respondents believed that climate risks have financial implications for their portfolios and that these risks had begun to materialize, with regulatory risk viewed as the most immediate. Many considered stock valuations of carbon-intensive firms too high relative to the risks. Rather than divesting, most investors preferred to manage climate risks through engagement with companies and through risk management. The respondents also reported that they were more likely to engage with firms when they had long investment horizons and held larger stakes. Surveys reveal beliefs and intentions that market data cannot, but they may overstate what investors actually do, which is the study's main limitation. The source will be used in the review's theme on investors, the people whose trades set prices, to explain the motives behind the price effects documented elsewhere, and to introduce the debate between engagement and divestment.

Painter, M. (2020). An inconvenient cost: The effects of climate change on municipal bonds. Journal of Financial Economics, 135(2), 468-482. https://doi.org/10.1016/j.jfineco.2019.06.006

Painter (2020) asks whether local governments exposed to climate change pay more to borrow. He finds that counties more likely to be affected by sea level rise pay higher underwriting fees and initial yields when they issue long-term municipal bonds, while short-term bonds show no such effect. The pattern is consistent with investors pricing a risk that will materialize over decades, and it grew stronger after investors' attention to climate risk increased. For a county facing long-term flood exposure, the added cost appears in every refinancing, so the price of risk compounds over time. The study is notable for bringing climate risk into public finance and for using maturity as a test of whether the risk is long-term. Its focus on sea level rise leaves other physical risks unexamined. The source will support the review's fixed income theme, showing that climate risk affects the cost of capital for governments as well as firms.

Pástor, Ľ., Stambaugh, R. F., & Taylor, L. A. (2021). Sustainable investing in equilibrium. Journal of Financial Economics, 142(2), 550-571. https://doi.org/10.1016/j.jfineco.2020.12.011

Pástor et al. (2021) build an equilibrium model in which some investors prefer to hold green assets and green assets also provide a hedge against climate risk. In this setting, green assets have lower expected returns than brown assets, because investors accept lower returns for holding assets they value. However, green assets can outperform when concern about climate change rises unexpectedly, since such shifts raise their prices. The model also implies that sustainable investing lowers the cost of capital for green firms, which can steer real investment. The model distinguishes carefully between expected returns, which are lower for green assets, and realized returns, which can be higher during periods of rising concern. As a theoretical paper it does not test these predictions directly, but it provides the framework the review needs to reconcile conflicting empirical findings. It will anchor the review's discussion of why green assets might have lower expected returns yet strong realized returns.

Pástor, Ľ., Stambaugh, R. F., & Taylor, L. A. (2022). Dissecting green returns. Journal of Financial Economics, 146(2), 403-424. https://doi.org/10.1016/j.jfineco.2022.07.007

In this empirical follow-up, Pástor et al. (2022) examine why green stocks outperformed brown stocks in the United States over the decade before 2020. They find that the outperformance came largely from unexpected increases in climate concerns, which raised green stock prices, rather than from higher expected returns. After removing the effect of these surprises, the return difference between green and brown stocks largely disappears. The authors warn investors not to extrapolate the strong past returns of green stocks, since the theory predicts lower expected returns going forward. The finding has a practical warning for fund managers who market green portfolios on the basis of past performance. The study directly tests the predictions of the authors' earlier model and is carefully executed, though its measure of climate concern relies on news coverage. The source will be paired with the 2021 model in the review to explain the gap between realized and expected returns on green assets.