Climate Targets and Sectoral Risk Premia

This paper develops a stochastic multi-sector climate-economy model to study how temperature targets, endogenous carbon pricing, and long-run macroeconomic risk shape sectoral asset prices. The model combines a reduced-form integrated assessment block with Epstein-Zin asset pricing. Sectors differ in productivity, carbon intensity, abatement costs, pass-through, and exposure to physical damages. For each temperature target, the policymaker commits to a target-consistent emissions path, and the carbon tax is determined endogenously, date by date and state by state, to implement it. The analysis delivers three main insights. First, stringent temperature targets are dominated by transition costs, whereas looser targets imply weaker transition pressure but larger long-run physical damages. Second, carbon intensity alone does not determine expected returns: endogenous carbon pricing can make brown sectors partly hedge-like, while stringent targets can generate substantial downside risk for high emitters. Third, once transition-cost and damage-exposure shifters are stochastic, the model generates both low- and high-premium brown-sector outcomes. The sign of the brown premium depends on the cyclicality of transition costs, pass-through, and the stochastic discount factor. The framework therefore connects climate targets to the cross section of sectoral risk premia in a tractable, scenario-consistent way.