Understanding climate risk in Europe: Are transition and physical risk priced in equity and fixed-income markets?

This study explores how climate-related risk factors influence the European equity and fixed-income markets. We examine the effect of specific physical risk drivers, including temperature fluctuations, drought, floods, wind, and wildfire risk, on both stocks and bonds. Additionally, we assess the impact of transition risk using two potential indicators: the log-returns of futures on European Carbon Allowances and a Transition Risk Index derived from credit default spreads. We also compare them to see if they carry the same information. Our findings reveal that climate risk variables have different effects on stocks and bonds, with stock returns appearing mostly unaffected by climate-related variables. In contrast, bond z-spreads show significant statistical relationships with both physical and transition climate risks. Physical risk, on average, rewards the green bonds in the sample, and penalizes the traditional bonds. As for transition risk, the two proxies are shown to capture different types of information and to affect different bonds. This suggests that credit default swaps are pricing a transition risk that goes beyond carbon emissions.