Do Transition Costs or Physical Damages Impact Equity Valuation More?

Summary:

The Journal of Portfolio Management, Novel Risks and Sources of Volatility Special Issue, Vol 51, Number 7, May 2025

The authors look at the relative impact of climate physical damages and transition costs in the valuation of a well-diversified global equity index. Under the reasonable assumption that transition costs can be proxied by the mitigation costs from standard integrated assessment models, they find that, contrary to common assumptions and practices, the impact on equity valuation of physical climate damages is of the same order of magnitude as transition costs and can easily be greater. Their results are robust and conservative. 
Because the impact of climate damages on asset valuation is rarely considered—and, when it is, it is usually deemed to be of minor import—these findings should be of interest and concern both to investors and to regulators.

Key findings:

• The authors look at the relative importance of transition costs and physical climate damages to the valuation of a global equity index and find that, contrary to the usual assumption, the latter are at least as large as the former—and often larger. 
• The authors also show that, because abatement efforts tend to be reduced in periods of economic distress, the impact of transition costs on valuation must be present-valued using state-dependent discount factors and the impact on valuation should be accounted for accordingly.
• Because investors and regulators have thus far focused mainly on transition costs, suggesting that an important component of the equity valuation sensitivity to climate change has so far been missed.

Article accessible in open access here: https://eprints.pm-research.com/17511/132373/index.html?93302