“Rising temperatures as a predictor of long-term equity return dynamics”

Historical data contain little information about the impact of future climate change on investment portfolios. We therefore combined historical data with a theoretical model that describes how rising temperatures influence asset prices. Three types of investor were considered: agnostic (historical data only) dogmatic (theoretical model only) and holistic (historical data combined with model). We examined these investors’ forecasts of equity premium and risk over different horizons and their implications for optimal long-run asset allocation.

 

Key Takeaways for the Industry

  • Equity premium rises with increasing temperature.
  • Rising temperatures result in increased equity market risk over the long run.
  • Incorporating climate change reduces the optimal allocation to equity for long-horizon investors.