Climate Change, Business Cycle and Asset Prices

Topic and Objetives

The ultimate goal of the project was to examine the long-run effects of rising temperature levels on key macroeconomic and financial aggregates by means of DSGE modeling. After having estimated the impact of temperature shocks on aggregate productivity in the United States using standard VAR analyses, we have embedded such evidence in a production-based asset-pricing framework featuring long-run productivity and temperature risk. Novel empirical and quantitative evidence has been collected in the SAFE Working Paper No. 177 “Temperature Shocks and Welfare Costs”. The paper has appeared in the Journal of Economic Dynamics and Control, Vol. 82, pp. 331-355 (2017). 

Many other intriguing research questions arose in the course of this project, resulting in several extensions of our analysis. In the same spirit of our first working paper on the economic impacts of climate change-related phenomena, we have accounted for temperature risk in a stochastic endogenous growth model. This with the main goal of examining climate effects on productive spending (i.e., R&D investments). The proposed model matches the provided novel empirical evidence on the impact of temperature shocks on R&D spending in the G7 countries.  These additional results can be found in the SAFE Working Paper No. 188 “Global Temperature, R&D Expenditure, and Growth”. 

As climate change may not only affect the average temperature level but also its variation, we produced novel empirical evidence on the relevance of temperature volatility shocks for the dynamics of macroaggregates and asset prices. Using two centuries of UK temperature data, we document that the relationship between temperature volatility and productivity and stock market returns is not constant over time. Actually, temperature volatility is found to undermine productivity and equity valuations only in the post-War period.  Temperature volatility shocks are also found to be priced in the cross-section of stock returns. These empirical findings are rationalized within a production economy featuring long-run productivity and temperature volatility risk.  

Climate research also suggests an increased occurrence of natural disasters due to global warming. Our most recent work studies empirically the effects of tornadoes on house prices and stock returns across four US regions (South, West, Mid-West, and North-East). We use state-level data to examine the impact of a shock to the size of tornadoes on house and asset prices in these four regions. We employ several empirical analyses such as VAR and panel estimations and cross-sectional asset pricing tests.

Key Findings

• Temperature shocks have a negative impact on both economic activity and financial markets by lowering long-run growth prospects and asset valuations.
• Welfare costs of rising temperatures amount to a sizeable loss of the agent’s lifetime utility.
• Temperature shocks have detrimental effects on investments in R&D and hence economic growth.
• Not only temperature level but also temperature volatility risk negatively affects financial markets, macroeconomic activity, and welfare.
• Temperature volatility shocks are priced in the cross-section of returns and command a positive premium.
• Tornado size shocks importantly contribute to house price dynamics in the South of the US which is the region most frequently affected by tornados. In this region, only Financials and Healthcare sectoral stock returns seem to be negatively affected by these shocks.

Policy Implications

• If economic agents manage to adapt to rising temperatures, e.g. by introducing new technologies, welfare losses could become smaller and might even turn into welfare gains (SAFE Working Paper No. 177).
• The government may offset welfare costs from temperature shocks by subsidizing capital investments or R&D expenditures, or alternatively by levying a lump-sum tax on households to make consumption relatively less attractive compared to investments (SAFE Working Paper No. 188).