This report examines the implications climate risk on capital markets and asset prices. Climate change is one of the most important issues in our generation and may have significant impacts on the economy. This report provides a comprehensive literature review on the relationship between climate risk and asset prices and conducts an empirical analysis to test whether transition risk is associated with stock returns in Korea. This reports aims to advance our understanding of the financial risks linked to climate change and its implications on asset prices.
The report begins by providing an introduction to financial risks caused by climate change. It explains the two main types of climate-related financial risks: physical risk, resulting from the natural disasters and weather changes due to climate change, and transition risk, resulting from the transition to a decarbonized economy. It discusses how physical and transition risks impact companies and transmit to the economy and financial markets.
The second chapter then surveys the literature on the relationship between climate risks and asset prices. The chapter reviews the rapidly growing literature that studies the effects of climate risk on asset prices, and finds that climate risks have substantial effects on the prices of assets that are exposed to such risks. This chapter then turns to discussion of scenario-based climate risk assessment methodologies and presents examples of climate stress testing by central banks.
Finally, the third chapter examines whether climate-related risks, in particular, transition risks, are priced in Korean stock market by using the compliance with the Korean emission trading scheme as a proxy for transition risks. The result shows that stocks of firms that are subject to the emission trading scheme, or relatively more exposed to transition risks, tend to have higher abnormal returns and this pattern is more pronounced after the Paris Agreement. This result thus indicates that transition risk may have significant effects on asset prices, and emphasizes the need to make efforts to understand the financial implications of climate risk and develop methodologies to assess the impact of climate risks.