BUSI 606 Week 8 Thematic Literature Review Example

Is Climate Risk Priced? A Thematic Review of the Literature on Climate Change and Financial Markets

Abstract

This review asks how far markets for stocks, bonds, options and homes reflect the risks that climate change creates. Drawing on 16 peer-reviewed studies, it is organized around four themes: transition risk in stock and options markets, physical risk in real estate, corporate profits and municipal finance, the pricing of green bonds, and investors' beliefs and hedging. The evidence shows that markets price climate risk in several forms, including a carbon premium in global equities, higher costs of downside protection for carbon-intensive firms and discounts on exposed homes and municipal bonds. It also shows that pricing is incomplete and uneven, with underreaction to slow-moving risks and only a small premium for green bonds. The review identifies gaps in measurement and in evidence outside developed markets and concludes with implications for investors and issuers.

Introduction

Financial markets exist to price risk, and few risks are as large, as long-lived or as hard to measure as those created by climate change. A warming climate threatens physical assets through floods, storms, heat and drought, and the policies, technologies and preferences that respond to climate change threaten the value of firms whose business depends on fossil fuels. These risks affect banks that lend against coastal property, insurers that cover weather losses, pension funds that hold the shares of energy companies and governments that borrow to rebuild after disasters. If markets price these risks accurately, capital will flow away from exposed assets and toward resilient ones; if they do not, investors may face sudden losses, and the cost of capital will fail to signal where risk lies.

Research on climate finance has grown rapidly in the past decade. In their review of the field, Giglio et al. (2021) distinguish two broad categories of risk. Physical risk refers to the direct damage climate change causes to assets and economic activity, whether from acute events such as hurricanes or chronic changes such as rising sea levels and drought. Transition risk refers to the losses that firms and investors may suffer as economies move away from carbon, through carbon pricing, regulation, technological change and shifts in consumer and investor preferences. The two risks can move in opposite directions: aggressive climate policy raises transition risk while reducing long-run physical risk.

The question for this review is whether, and how accurately, prices reflect these risks. It is organized thematically. The first theme examines transition risk in stock and options markets; the second, physical risk in real estate, corporate profits and municipal bonds; the third, the pricing of green bonds; and the fourth, the beliefs and strategies of the investors whose trades set prices. A synthesis compares the themes, and the review closes with gaps, a biblical perspective and implications for practice. The review draws on peer-reviewed research in finance and economics, emphasizing studies that use market prices to infer what investors believe.

The topic belongs squarely within the study of global financial markets. Every market the course covers plays some part in how climate risk is transferred and priced. Equity investors bear the residual risk of firms exposed to policy change; bondholders, including buyers of municipal debt, lend against assets that may be damaged; derivatives markets allow investors to insure against sudden losses; and banks hold loans secured by property in exposed areas. Understanding whether each of these markets prices climate risk accurately is therefore a test of how well the global financial system as a whole performs its basic function of allocating capital according to risk.

Scope and Method of the Review

Sources were located through searches of finance and economics databases for studies linking climate change to asset prices, using terms such as climate risk, carbon emissions and stock returns, sea level rise, green bonds and climate finance. The review concentrates on peer-reviewed articles in leading finance, accounting and economics journals, because these studies use market data and have been tested by referees, and it includes one review article to provide structure. Studies were selected if they addressed how a market prices climate exposure or how investors think about it, and they were grouped by the asset or participant they examine.

The studies reviewed use several methods, and their strengths and weaknesses shape the conclusions. Many equity studies regress stock returns on measures of carbon exposure while controlling for known risk factors; this approach uses large samples but depends on the quality of emissions data and on whether the controls capture other differences between firms. Studies of physical risk often compare matched assets, such as nearly identical homes with different flood exposure, which isolates the effect of climate exposure but covers narrower settings. Event studies, like those of green bond announcements, measure investors' immediate reactions but cannot by themselves show long-run effects. Surveys reveal beliefs that prices alone cannot, but they record what respondents say rather than what they do. Options-based studies capture expectations about extreme outcomes but cover mainly large firms. Because each method has blind spots, the review gives most weight to conclusions supported by more than one method.

Theme 1: Transition Risk in Stock and Options Markets

The most extensive body of research asks whether the stocks of carbon-intensive firms are priced differently from those of cleaner firms. In theory, two forces could operate. If investors see carbon-intensive firms as exposed to future policy and technological change, they should demand higher expected returns to hold them, creating a carbon premium. If, instead, some investors simply prefer to hold cleaner firms, those firms' prices will be bid up and their expected returns will be lower, which also implies higher expected returns for carbon-intensive firms but for a different reason.

Bolton and Kacperczyk (2021) provided the first large-scale evidence for U.S. stocks. Linking firm-level data on emissions to stock returns, they found that firms with higher emissions, and particularly firms whose emissions were growing, earned higher returns after controlling for standard risk factors and firm characteristics. They interpreted the pattern as a premium for transition risk, and they found that institutional investors held less of the most emission-intensive firms in some industries, consistent with exclusionary screening. In a later study covering firms in 77 countries, Bolton and Kacperczyk (2023) found that the carbon premium was a global phenomenon, appearing across sectors and regions, and that its magnitude varied with country characteristics, including the stringency of national climate policy. Together, the two studies suggest that equity markets around the world treat carbon exposure as a priced risk.

A theoretical framework developed by Pástor et al. (2021) helps interpret these findings while adding an important qualification. In their equilibrium model, some investors derive satisfaction from holding green assets, and green assets also hedge climate risk, so investors accept lower expected returns on them. Brown assets, by implication, have higher expected returns. Yet the model also predicts that green assets can deliver higher realized returns for long stretches if concern about climate change rises unexpectedly, because rising concern pushes up their prices. Pástor et al. (2022) tested this prediction and found that the strong performance of green stocks relative to brown stocks in the United States during the 2010s was explained largely by unexpected increases in climate concern rather than by higher expected returns. Once the effect of these surprises was removed, green stocks would not have outperformed.

The equity evidence therefore points to a premium for carbon risk that can be hidden for years by shifts in sentiment. This reconciles what might otherwise look like a contradiction: brown stocks may carry higher expected returns even during a period in which green stocks performed better. For investors, the implication is that past returns are a poor guide to the pricing of climate risk, and that the relevant question is how expected returns, and therefore the cost of capital, differ across firms.

Options markets offer a different window, because option prices reveal how much investors will pay to protect against large price declines. Ilhan et al. (2021) showed that insuring against a crash cost more for the shares of heavy emitters, a sign that investors perceived a greater risk of sudden losses at these firms. The effect strengthened when public attention to climate change was high, suggesting that investors associated carbon intensity with the possibility of abrupt policy changes. This evidence complements the equity studies: stock returns show that investors require compensation for carbon exposure on average, while option prices show that they fear its extreme outcomes.

The equity literature has limitations. Emissions data for many firms are estimated by data providers rather than reported, and estimates can differ substantially, which introduces measurement error. The interpretation of the carbon premium also remains debated, since higher returns for high-emission firms could reflect differences in profitability or in industry composition rather than compensation for risk. Still, the convergence of evidence from U.S. and global stock returns and from options prices makes a strong case that transition risk is priced in equity markets.

For corporate managers, the equity evidence has a direct implication: a firm's carbon exposure appears to raise its cost of equity capital. A higher expected return demanded by investors is, from the firm's side, a higher hurdle for new investment. Firms that credibly reduce their emissions, or their exposure to policy changes, may therefore lower their cost of capital over time, while firms that expand carbon-intensive operations may find external financing more expensive. The size of this effect is debated, and it depends on how investors interpret emissions data, but it gives managers a financial reason, in addition to any regulatory requirement, to understand and disclose their exposure. It also suggests that the course's standard tools for valuing projects, which discount future cash flows at a rate reflecting risk, should incorporate climate exposure when estimating that rate.

Theme 2: Physical Risk in Real Estate, Corporate Profits and Municipal Finance

Physical risk is local, which makes it well suited to studies that compare otherwise similar assets with different exposure. Real estate provides the clearest test. Bernstein et al. (2019) compared coastal homes that would be inundated under projected sea level rise with similar homes nearby that would not, and found that the exposed homes sold at a discount of roughly seven percent. Notably, the discount was concentrated among sophisticated buyers, such as investors who would not occupy the homes, and was larger in communities with greater concern about climate change. Owner-occupants, who might rely more on current conditions and less on long-term projections, appeared to price the risk less.

Public finance shows a similar pattern. Painter (2020) turned to municipal bonds and found that counties facing greater projected exposure to rising seas paid higher underwriting fees and higher initial yields on long-term bonds, while short-term bonds were unaffected. The maturity pattern is telling: investors appeared to price a risk that would materialize over decades, not one that threatened repayment within a few years. The effect also grew after climate risk received more public attention, consistent with the role of attention found in the options literature.

Not all evidence suggests efficient pricing. Hong et al. (2019) examined drought, a slow-moving physical risk, and found that long-term trends toward drought in a country foreshadowed weaker earnings at food producers in that country. More importantly, those trends also predicted poor stock returns, meaning that investors had not fully incorporated the information into prices when it became available. The authors interpreted this as underreaction to climate risk, a form of market inefficiency, perhaps because slow changes attract less attention than sudden disasters.

The physical risk literature thus presents a mixed picture. Markets appear to price exposure to sea level rise in housing and municipal debt, at least among sophisticated participants and for long horizons, but they may underreact to gradual risks such as drought that unfold without dramatic events. A common thread is the role of attention and sophistication: risks are priced more fully when they are salient and when the investors setting prices have the expertise to assess long-term projections. This suggests that pricing may improve as climate information becomes more widely available, but also that markets may move abruptly when risks suddenly become salient.

These findings matter beyond the households and governments directly exposed. Banks hold mortgages on coastal homes and buy municipal bonds, and insurers provide the coverage that makes those mortgages possible. If owner-occupants and some lenders underprice flood risk, losses could accumulate on the balance sheets of financial institutions and appear suddenly if insurers withdraw from exposed areas or premiums rise sharply. The evidence that sophisticated buyers already discount exposed homes implies that some of this repricing has begun. For lenders, the practical lesson is that collateral values in exposed areas may be overstated by recent sales prices, and loan terms and capital planning should account for the possibility that prices will adjust further as climate projections are more widely understood.

Theme 3: Green Bonds and the Search for a Greenium

Green bonds, whose proceeds are designated for environmentally beneficial projects, have grown from a niche product into a significant segment of global bond markets. Two questions dominate the research: whether investors accept lower yields on green bonds than on comparable conventional bonds, a difference known as the greenium, and whether issuing green bonds changes the issuer's behavior.

On pricing, the evidence points to a small premium at most. Zerbib (2019) matched green bonds with otherwise similar conventional bonds from the same issuers and found that green bonds traded at slightly lower yields, by only a couple of basis points on average, a difference he attributed to investors' environmental preferences but which is economically modest. Larcker and Watts (2020) used a particularly clean comparison in the U.S. municipal market, where many issuers sell green and conventional bonds on the same day with otherwise identical features, and found essentially no difference in yields, concluding that investors were unwilling to give up return for the green label. Baker et al. (2022) reported a small premium for U.S. green bonds, larger for bonds whose green status was certified by an outside party, and found that green bonds were held more closely by fewer investors than conventional bonds, consistent with a clientele of investors who value the green feature.

The differences among these studies reflect their samples and methods. Municipal and corporate green bonds also differ in important ways. A municipality's green bond typically finances a specific project, such as a water system, whose environmental character is easy to observe, while a corporation's green bond finances projects within a larger firm whose overall emissions may continue to rise. Investors may therefore value certification more for corporate issues, where the link between the bond and the issuer's environmental performance is harder to verify. Same-day issues by the same municipality allow the cleanest comparison and show little or no premium, while broader samples that rely on matching across issues find a small one. Certification appears to matter, which suggests that investors pay for credible evidence that proceeds will be used as promised.

On behavior, Flammer (2021) found that stock prices rose when companies announced green bonds, especially first-time issues and certified bonds, and that issuers afterward reduced their emissions and received higher environmental ratings while attracting more long-term and green-oriented investors. These findings suggest that corporate green bonds work less as a source of cheaper funding than as a credible signal of environmental commitment. If green bonds matter, the evidence suggests they matter for what they reveal about issuers rather than for the yields they offer. For issuers, this means that the decision to issue green bonds should rest on strategy and credibility rather than an expected saving on interest costs.

The importance of certification connects the green bond literature to a broader concern about greenwashing, the practice of labeling investments as green without meaningful environmental benefit. If investors cannot verify how proceeds are used, the green label loses its value, and any premium disappears. Standards developed by market associations and, more recently, by regulators such as the European Union aim to define what qualifies as green and to require reporting on the use of proceeds and the impact achieved. The research reviewed here suggests that such standards could matter more for the green bond market than any interest saving, because the market's value rests on credible information. A remaining question is whether green bonds finance projects that would not otherwise have been undertaken, or simply relabel investments firms would have made anyway; the evidence that issuers' emissions fall after issuance is encouraging but does not fully settle the question.

Theme 4: Investors' Beliefs and Hedging Strategies

Prices reflect the beliefs and actions of investors, and several studies ask investors directly what they think. Krueger et al. (2020) surveyed institutional investors and found that most believed climate risks had financial implications for their portfolios and that some of these risks had already begun to materialize. Respondents saw regulatory risk as the most immediate, and many believed that the valuations of carbon-intensive firms did not fully reflect climate risks. When asked how they managed these risks, investors favored engagement with companies and risk management tools over outright divestment, with long-term and larger investors more likely to engage.

Stroebel and Wurgler (2021) surveyed a broader group of academics, policymakers and financial professionals about climate finance. Respondents viewed regulatory risk as the top climate risk to businesses and investors over the next five years and physical risk as the top risk over a 30-year horizon. A large majority believed that asset prices understated climate risks, a view that contrasts with the studies finding a priced carbon premium and suggests that experts believe pricing, while present, is incomplete.

If climate risks are not fully diversifiable, investors need ways to hedge them. Engle et al. (2020) proposed a method based on news: they built an index of climate-related news from newspaper text and constructed stock portfolios, using firms' environmental scores, whose returns rose when climate news worsened. These portfolios hedged climate news out of sample, providing a practical tool. The approach depends, however, on environmental ratings that may measure firms' climate exposure imperfectly, a limitation that recurs throughout the literature.

The investor literature helps explain the pricing evidence. If many investors believe climate risks are underpriced, engage rather than divest and only gradually update their views as attention rises, prices would be expected to reflect climate risk partially and to adjust in bursts when attention shifts. That is close to the pattern the previous themes describe.

The preference for engagement over divestment also has implications for prices. Divestment, if practiced widely, would lower the prices of carbon-intensive firms and raise their expected returns, which is consistent with the carbon premium documented in equity markets. Engagement, by contrast, seeks to change firms' behavior and thereby reduce their exposure, which would lower the premium over time if successful. The two strategies thus have different effects on the cost of capital, and the balance between them helps determine how much financial markets push firms toward lower emissions. Evidence on whether engagement actually changes corporate emissions remains limited, and the survey evidence that investors prefer engagement does not by itself show that it works, which is one reason the question appears among the gaps identified below.

Synthesis: Priced, but Incompletely

Taken together, the four themes support a qualified conclusion: financial markets do price climate risk, but incompletely and unevenly. The strongest evidence of pricing comes from transition risk in equity and options markets, where carbon exposure is associated with higher expected returns and costlier downside protection, and from physical risk in markets for long-lived assets such as coastal homes and long-term municipal bonds. The evidence of incomplete pricing comes from the underreaction to drought trends, the small or absent greenium and the widespread belief among experts and investors that prices understate climate risk.

Three factors help reconcile these findings. First, attention matters: several studies find that pricing strengthens when climate risk becomes more salient, implying that markets incorporate climate information in steps rather than continuously. Second, investor sophistication matters: sophisticated buyers price sea level rise in housing more than owner-occupants do, and institutional investors are the ones whose holdings shift with carbon exposure. Third, measurement matters: emissions data and environmental ratings are imperfect, so different studies may be measuring somewhat different things, which contributes to disagreement.

The synthesis has practical implications. For investors, it suggests that climate risk is a real factor in expected returns and that portfolios exposed to carbon-intensive firms or vulnerable physical assets should be evaluated accordingly, without extrapolating recent green outperformance. For issuers, it suggests that climate exposure affects the cost of capital, so investments that reduce exposure may be rewarded over time. For regulators, the evidence that pricing depends on attention and information supports policies that improve disclosure of climate exposure.

The synthesis also connects to the course's broader study of global markets. Climate risk is priced in markets across regions, as the global equity evidence shows, but the institutions that support pricing, disclosure rules, data providers and sophisticated investors, are unevenly distributed. Markets in Europe have moved faster than many others to require climate disclosure, while many emerging markets, where physical risks are often largest, have the least data. Capital flows across borders may therefore reflect climate risk better in some directions than others, and international coordination on disclosure standards could improve pricing where it is currently weakest.

Gaps in the Literature

The literature leaves several questions open. The first is measurement. Much of the equity research relies on emissions estimates and environmental ratings that vary across providers, and better standardized disclosure would allow sharper tests. The second is geography. Most studies examine the United States and other developed markets; the global study of the carbon premium is an important exception, but evidence on physical risk and green bonds in emerging markets, where climate exposure is often greatest, remains limited. The third is the distinction between risk and preference. Researchers have not fully separated the portion of price differences that compensates investors for risk from the portion that reflects investors' preferences for green assets, which matters for whether climate pricing signals risk or values. A further gap concerns time. Most studies cover periods of a decade or two, while climate risks unfold over many decades, so it is difficult to know whether today's pricing reflects long-run risks or recent shifts in attention. Longer samples and studies that follow how prices respond to new climate science would help. Finally, few studies examine the banking system, through which much climate exposure flows to the economy in the form of loans, and research connecting the pricing of climate risk in securities markets with its treatment in bank lending would be valuable.

A Biblical Perspective on Long Horizons and Stewardship

Climate risk forces investors to think about long horizons, a theme with deep roots in Scripture. According to Proverbs 13:22, a good man's legacy reaches his grandchildren, a vision of stewardship that extends beyond a single generation. The finding that markets price sea level rise only for long-maturity bonds and only among sophisticated buyers suggests that taking the long view does not come naturally to markets; it must be cultivated.

Scripture also presents the earth as entrusted to human care. Genesis 2:15 gives the first human both tasks at once, cultivating the garden and guarding it, so that productive use and preservation belong together. For Christians in finance, the evidence reviewed here suggests that faithful stewardship includes pricing risks honestly, including risks that will fall on future generations, and disclosing them fully to those who entrust their savings to the financial system. Accurate pricing of climate risk is not a political position but a matter of truthfulness about the value of assets. A Christian analyst who reports that a portfolio's climate exposure is understated is not advancing an agenda but practicing the honesty that stewardship of other people's money requires.

Conclusion

This review has examined research on how far the prices of financial assets reflect climate risk. Across stock, options, housing and bond markets, the evidence shows that climate risk is priced: carbon-intensive firms carry higher expected returns and costlier protection against sudden losses, and exposed homes and municipal borrowers face discounts and higher borrowing costs. The pricing is incomplete, however, as shown by underreaction to slow-moving risks, the small premium on green bonds and the view of many investors that climate risks remain underpriced. Attention, sophistication and measurement help explain these patterns.

For participants in global financial markets, the main implication is that climate risk has moved from the margins of finance to its center. Investors who ignore it risk mispricing their portfolios, issuers who ignore it risk higher costs of capital, and regulators who ignore it risk a financial system exposed to sudden repricing. Further research on measurement, emerging markets and the banking system will clarify how far markets have to go before climate risk is priced as fully as other well-understood risks.

Several practical recommendations follow from the evidence. Portfolio managers should measure their holdings' exposure to both transition and physical risk, recognizing that the two can move in opposite directions, and should test portfolios against scenarios in which climate concern rises suddenly. They should be cautious about marketing green strategies on the basis of past returns, which the research shows can reflect shifts in sentiment rather than higher expected returns. Corporate financial officers should treat climate exposure as a component of the firm's cost of capital and should consider whether credible commitments, such as certified green bonds tied to measurable outcomes, could strengthen investors' confidence. Lenders and insurers should examine whether collateral values in exposed areas reflect long-term projections or only recent sales. And all participants should expect that improved disclosure will make climate exposure more visible, which may cause prices to adjust in steps as information arrives.

References

Baker, M., Bergstresser, D., Serafeim, G., & Wurgler, J. (2022). The pricing and ownership of US green bonds. Annual Review of Financial Economics, 14, 415-437. https://doi.org/10.1146/annurev-financial-111620-014802

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

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, 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

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

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

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

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

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

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

Larcker, D. F., & Watts, E. M. (2020). Where's the greenium? Journal of Accounting and Economics, 69(2-3), Article 101312. https://doi.org/10.1016/j.jacceco.2020.101312

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

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, 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

Stroebel, J., & Wurgler, J. (2021). What do you think about climate finance? Journal of Financial Economics, 142(2), 487-498. https://doi.org/10.1016/j.jfineco.2021.08.004

Zerbib, O. D. (2019). The effect of pro-environmental preferences on bond prices: Evidence from green bonds. Journal of Banking & Finance, 98, 39-60. https://doi.org/10.1016/j.jbankfin.2018.10.012