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A portfolio approach to climate investments: CAPM and endogenous risk

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  • Maria Sandsmark
  • Haakon Vennemo

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Abstract

Is there a role for investments in climate change mitigation despite low expected return? We use a model of intertemporal expected utility maximisation to analyse this question. Similar to the capital asset pricing model (CAPM) the rate of return depends on the correlation of risk between the return on investments in climate change mitigation and the market portfolio, but in contrast to the classical CAPM we admit the fact that economic and environmental systems are jointly determined, implying that environmental risk is endogenous. Therefore, investments in climate change mitigation may reduce risk via self-protection and self-insurance. If risk reduction is accounted for in cost–benefit evaluations, climate investments may be justified despite low expected return. These aspects of climate investments are not, however, communicated via standard cost–benefit analyses of climate policy. Optimal climate policy may therefore be more ambitious than previously considered. Copyright Springer Science+Business Media, Inc. 2007

Suggested Citation

  • Maria Sandsmark & Haakon Vennemo, 2007. "A portfolio approach to climate investments: CAPM and endogenous risk," Environmental & Resource Economics, Springer;European Association of Environmental and Resource Economists, vol. 37(4), pages 681-695, August.
  • Handle: RePEc:kap:enreec:v:37:y:2007:i:4:p:681-695 DOI: 10.1007/s10640-006-9049-4
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    References listed on IDEAS

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    Citations

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    Cited by:

    1. Hjort, Ingrid, 2016. "Potential Climate Risks in Financial Markets: A Literature Overview," Memorandum 01/2016, Oslo University, Department of Economics.
    2. Simon Dietz & Christian Gollier & Louise Kessler, 2015. "The climate beta," GRI Working Papers 190, Grantham Research Institute on Climate Change and the Environment.
    3. Christian Gollier, 2012. "Evaluation of Long-Dated Investments under Uncertain Growth Trend, Volatility and Catastrophes," CESifo Working Paper Series 4052, CESifo Group Munich.
    4. Martin L. Weitzman, 2013. "Tail-Hedge Discounting and the Social Cost of Carbon," Journal of Economic Literature, American Economic Association, pages 873-882.
    5. Gollier, Christian, 2016. "Evaluation of long-dated assets: The role of parameter uncertainty," Journal of Monetary Economics, Elsevier, pages 66-83.
    6. Sakib Mahmud & Gazi Mainul Hassan, 2014. "Consequences of Public Programs and Private Transfers on Household Investment in Storm Protection," Working Papers in Economics 14/01, University of Waikato.
    7. Rob Aalbers, 2013. "Optimal Discount Rates for Investments in Mitigation and Adaptation," CPB Discussion Paper 257, CPB Netherlands Bureau for Economic Policy Analysis.
    8. Martin L. Weitzman, 2012. "Rare Disasters, Tail-Hedged Investments, and Risk-Adjusted Discount Rates," NBER Working Papers 18496, National Bureau of Economic Research, Inc.

    More about this item

    Keywords

    CAPM; climate change; endogenous risk; climate investment; risk management; D81; G12; Q28;

    JEL classification:

    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • Q28 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Renewable Resources and Conservation - - - Government Policy

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