Transition versus physical climate risk pricing in European financial markets: a text-based approach

Abstract

Under its climate regulation, the EU is expected to become the first continent with a net-zero emissions balance. We study the pricing of climate risks, physical and transition, within European markets. Using text-analysis, we construct two novel (daily) physical and transition risk indicators for the period 2005–2021 and two global climate risk vocabularies. Applying our climate risk indices to an asset pricing test framework, we document the emergence of economically significant transition and physical risk premia post-2015. From a firm-level analysis, using firms' GHG emissions, GHG emissions intensity, environmental, and ESG scores, we find that rises in transition (physical) risk are typically associated with an increase (decrease) in the return of green (brown) stocks. Firm-level information is used by investors to proxy firms' climate-risks exposure, especially for transition risk since 2015, whereas the sectoral classification appears to proxy firms' exposures to physical risk. From a country-level analysis emerges an intensified connection between European stock markets and climate risks post-2015, yet with some heterogeneity. Our results have important economic implications and show that investors demand compensation for their exposure to both climate risk types. Our novel climate risk vocabularies and indicators find several applications in identifying, measuring, and studying climate risks.