ENVIRONMENT AND FINANCIAL MARKETS: ASSESSMENT AND RISK

Abstract

This dissertation examines how climate risk, decomposed into transition risk and physical risk, is priced across G7 equity markets and the US fixed income market over the period February 2016 to May 2025. Using a Transition Risk Index (TRI) and a Physical Risk Index (PRI) as the primary explanatory variables, alongside monthly benchmark equity index returns for all seven G7 countries and monthly US 10-year Treasury yield data, this study conducts six empirical analyses: pooled and fixed effects panel OLS regressions, a time-series OLS of climate risk on bond yield changes, 24-month rolling regressions to capture time-varying sensitivity, individual country level regressions, portfolio level Climate Value at Risk (Climate VaR), and an analysis of bond-equity correlation dynamics under climate stress. The results show that transition risk exerts a statistically significant and negative effect on G7 equity returns in pooled OLS (beta = −0.312, p < 0.001), a finding that is robust to the inclusion of country fixed effects. In the bond market, higher transition risk is associated with rising yields, significant at the 5% level. Physical risk, by contrast, does not show significant pricing in either market, a finding consistent with the hypothesis that markets are slow to incorporate gradual climate trends. The Climate VaR analysis reveals that equity tail risk increases meaningfully during periods of high transition risk. Rolling regressions reveal that the sensitivity of equity returns to both risk indices is not stable over time, with notable shifts around the COVID-19 period and the Russia-Ukraine conflict. Taken together, these findings suggest that while transition risk is increasingly priced into G7 financial markets, physical risk remains systematically underweighted, a market inefficiency with implications for portfolio construction and climate-related financial regulation.