A fast-growing body of literature examines whether physical and transition risks related to climate change are adequately priced in financial markets. While there is growing evidence that financial markets have started to price in climate risks, many have expressed concerns that current prices do not fully reflect these risks (BIS (2020), IMF (2020), NGFS (2022), ECB (2021), OECD (2021), Campiglio et al (2022)).

Uncertainty and imperfect information complicate pricing. Also, externalities associated with climate change and greenhouse gas emissions can lead to a disconnect between market prices and the true social costs (Nordhaus (2019)).

Uncertainty across multiple dimensions and the long-run nature of climate risks present significant challenges to accurately modelling these risks (Hansen (2022), Barnett et al (2020)). Investors grapple with uncertainty about the future path of climate change, and about the energy transition, policy parameters and adaptation by firms and households. Market pricing is also hampered by a lack of historical data, consistent methodologies, standardised metrics, and comparable disclosures around climate risks (BIS (2020)). Even if investors had perfect information, risks far into the future may not be reflected in asset prices unless discount rates are sufficiently low.

A survey of finance academics and professionals, public sector regulators and economists in July 2021 identified regulatory risk as the top risk over the next five years and physical risk as the top one over the next 30 years (Stroebel and Wurgler (2021)). An overwhelming majority of survey respondents believed that asset prices underestimated climate risks.

This paper summarises the main findings of the literature on the pricing of climate risks in financial markets, including some unpublished work not yet subjected to peer review. More comprehensive reviews of the literature can be found in BCBS (2021), ECB (2021), NGFS (2022) and Giglio et al (2021a).