A portfolio approach to climate investments: CAPM and endogenous risk

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