Impact of Physical Climate Risks on Financial Assets

Climate change poses substantial risks to global socioeconomic stability. The financial sector of the
economy could be affected by climate risks both independent of the real sector and due to the linkages
with the real sector. Understanding these linkages is crucial not only to prevent the vulnerability of the
financial sector to climate risks but also to effectively utilize the financial markets to raise finance for
mitigation and adaptation efforts. This paper explores the impacts of physical climate risks on the risk
premia of financial assets. We employ a range of climate indicators representative of chronic and extreme
climate risks and a mix of panel regressions, machine learning, and local projections to examine the
contemporaneous and persistent effects of physical climate risks on financial assets. We also investigate
the exposure of different economic subsectors and assets to physical climate risks. We observe that
employing a suite of climate indicators enriches the understanding of the impacts of physical climate risks
on financial assets. Most of these pathways align with the impacts on the real sector of the economy via
sectoral productivity. The physical climate risks could have persistent effects for several years, both at the
aggregate and sectoral levels. Different assets could experience similar effects, although safer assets
could reduce the exposure of asset portfolios to climate risks.