Shortly after Asset Diversification and Climate Action found its home in the International Economic Review, I am pleased to present its sibling Pricing in Transition and Physical Risks: Carbon Premiums and Stranded Assets.
In this follow-up paper, Rick van der Ploeg and I study a global DSGE model where consumption goods are produced by both a green and a carbon-intensive sector and reallocation of capital is subject to intrasectoral adjustment costs. We allow for several types of economic and climate-related risks including irreversible tipping of the climate system. Transition risks consist of technological breakthroughs in negative emissions technologies and changes in political regime, where the latter are either business as usual, optimal climate policy, or a temperature cap. Climate and technological tipping can affect political tipping. We show how transition and physical risks affect the carbon price, the risk-free rate, the risk premiums of green and brown assets. Transition risks can trigger asset stranding if a government introduces a temperature cap and bans further carbon emissions. These risks are priced in and lead to sizable carbon risk premiums.