Policy transition risk, carbon premiums, and asset prices

Layer 1: Overview

Research question and motivation: Central bankers, regulators, and investors increasingly worry about climate “transition risks” — abrupt shifts in climate policy, green technology breakthroughs, or consumer-preference shifts that re-price assets (Carney’s “tragedy of the horizon”). Rather than use the fixed NGFS-style stress-test scenarios, the authors ask how policy transition risk — modeled as stochastic, reversible jumps between climate-policy regimes — endogenously affects carbon pricing, asset prices, risk premiums, the risk-free rate, and the speed of the green transition.

Model setup: A global two-sector continuous-time DSGE macro-finance model of the climate and economy (building on Hambel, Kraft, van der Ploeg 2024). Two sectors produce perfectly substitutable final goods via Cobb-Douglas in capital and a CES energy composite of fossil fuel and renewables; sector 1 is “green” (renewables-intensive) and sector 2 is “brown” (fossil-intensive). Investment carries quadratic intertemporal adjustment costs and brown-to-green capital reallocation carries quadratic intrasectoral costs (a dollar of brown converts to less than a dollar of green). Temperature rises in cumulative emissions (TCRE specification). Households have Epstein-Zin recursive preferences; dividends are leveraged consumption (D=C^phi, phi>1). Capital is exposed to Brownian shocks plus Barro-style macro-disaster jumps; learning-by-doing lowers renewable costs. The core model has a two-state policy Markov chain — BAU (no carbon pricing) and CAP (carbon pricing internalizing damages and enforcing a Tcap=2C cap; if the cap is breached, fossil use is forced to zero). Policy tips with transition intensity calibrated at lambda_x = 4% per year from BAU to CAP. Model solved by finite differences; 20,000 simulated paths to 2100. Calibration: RRA gamma=2.977, EIS psi=1.5, time preference delta=0.0346, initial GDP $116tn, initial brown-capital share S0=0.876, TCRE=1.8 C/TtC, T0=1.27C.

Main quantitative findings: (1) Under pure BAU, the green transition is slow and temperatures reach on average 3.9C above pre-industrial by 2100; risk-free rate and risk premiums are almost unaffected (TFP damage alone cannot generate a temperature premium). (2) With policy transition risk, by 2100 about 28% of paths stay below 1.8C, 46% land between 1.8C and 2.5C, and the rest exceed 2.5C; roughly 45% of paths adhere to the 2C cap; 94% of paths have active climate policy by 2100. On the illustrative path tipping to CAP in 2045, a carbon price of $700/tC ($190/tCO2) is imposed; the green share price jumps +22% and the brown price drops -21.5% on impact. In the ~4% of paths where CAP is adopted in 2021, the carbon tax starts at ~$218/tC ($60/tCO2), about 50% larger than Pigouvian pricing without an enforced cap — because the cap forces policymakers to catch up. (3) The model generates a sizable, positive carbon premium (brown minus green risk premium) that is initially near zero but becomes large when temperature is close to or above the 2C cap and the economy is still carbon-intensive; the dominant channel is the asymmetric temperature-shock impact on the brown sector’s price-dividend ratio (third term of eq. 3.4). Without transition risk (first-best Pigouvian pricing), the carbon premium is slightly negative. (4) The mean risk-free rate starts at 0.8% and is largely stable, but its lower quantile falls sharply when temperature approaches/exceeds the cap as precautionary saving rises. (5) Extensions table: in the pure PIGOU scenario (no cap, no transition risk) climate disasters roughly double the optimal carbon tax from $45/tCO2 (2025) to $91, and adding irreversible climate tipping raises it to $121; in the core BAU->CAP model the average optimal CO2 tax rises from $73 to $108 (disasters) to $134 (tipping). News effects on share prices are far larger for policy tips than for climate or technology tips (climate tipping events move prices ~3-5%; a BAU->CAP tip moves the brown price ~-27% and brown price-dividend ratio ~-13%, green price +18%, green PDR +42%).

Implications: Policy transition risk makes average policy more ambitious than BAU but less than first-best; it produces risk-driven carbon premiums that accelerate the green transition, raises precautionary saving, and depresses the risk-free rate near the cap. Physical risks alone (assumed symmetric across sectors) cannot generate a sizable carbon premium but do raise carbon prices and create a temperature risk premium on all assets.

Layer 2: Deep Dive

What is the identification strategy, and what are the main threats to it?

This is a calibrated structural (DSGE) model, not an empirical identification design, so ‘identification’ here means the model mechanism that generates carbon premiums plus calibration to external sources. The carbon premium is generated purely endogenously by making the brown sector more fossil-/carbon-intensive than the green sector, with physical risks assumed to load symmetrically on both capital stocks so any premium asymmetry comes from policy transition risk and temperature exposure rather than from differential physical-risk loadings. The main threats the authors acknowledge are: (i) calibration choices for negative-emissions cost curves and transition probabilities are ’tentative’ and partly curve-fit/ad hoc; (ii) exogenous and stark policy states (two or three regimes with given/partly exogenous transition intensities) are a simplified representation of the political process; (iii) global-economy calibration sits uneasily with national-election interpretations of policy tipping. They argue the forward-looking households/firms make the model robust to the Lucas critique.

What are the main mechanisms, and how are they distinguished?

Three channels for the carbon premium appear in equation (3.4): (1) a stochastic-discount-factor/transition-shock term scaling in transition intensities lambda_x; (2) a diffusive term from the volatility of the brown-capital share affecting the brown price-dividend ratio more (largest when S(1-S) is high, i.e. share neither very high nor very low) and from higher consumption-capital-ratio volatility in the brown sector combined with leverage; (3) a temperature-shock term that becomes large near 2C because the policy transition to CAP becomes potentially devastating (forced phase-out of fossil fuel) and hits the brown PDR much more than the green PDR. The authors state the third (temperature-near-cap) effect is quantitatively the most important. The premium is risk-driven, distinguished from preference-driven mechanisms (Pastor et al. 2021; Pedersen et al. 2021; Zerbib 2022) in which green investors accept lower returns.

What heterogeneity is documented?

Heterogeneity is across states and paths rather than across firms in data. The carbon premium and risk-free-rate response depend nonlinearly on temperature (large near/above 2C) and on the brown-capital share S (large transition effect when S is high). Across simulated paths the outcomes diverge widely: ~28% below 1.8C, ~46% between 1.8C and 2.5C, the rest above 2.5C by 2100. The price impact of news differs sharply by type: policy tips dominate climate tips and technology tips. The risk-free rate’s lower quantile falls much more in high-temperature paths.

What robustness checks and extensions are run?

Extensions: (a) recurring temperature-dependent climate disasters (intensity rising linearly in T, lambda_c-hat=0.096, lambda_c(T0)=0.122, expected loss 1.5% vs 25% for macro disasters, alpha_c=65.7); (b) irreversible climate tipping via a 3-state chain raising TCRE from 1.8 to 2.1 to 2.4 C/TtC and adding permanent damages d=0,0.025,0.05; (c) a negative-emissions/technology-breakthrough state (2-state chain, ~50% chance of competitive technology by 2050, intensity 0.0224, cost curve fit to Rebonato et al. 2023); (d) a richer 3-state policy chain BAU/PIGOU/CAP with reversible and partly endogenous transition probabilities (switch to active policy rising toward 75% if T>1.5C; lobbying makes switches depend on brown/green capital shares), giving an 18-state (2x3x3) Markov chain. Core qualitative results (positive carbon premium driven by policy risk near the cap, precautionary saving lowering the risk-free rate) survive all extensions; the carbon premium is smaller in the 3-state model because only ~30% of paths reach CAP. A model variant with exhaustible fossil resources (cap 3000 GtC) found the exhaustibility constraint non-binding.

How does this paper relate to and differ from closely related prior work?

It extends Hambel et al. (2024), which used a two-sector economy for climate disasters/tipping and first-best carbon prices but did not study policy transition risk or carbon premiums. It builds general-equilibrium structure on the partial-equilibrium reduced-form insights of Hsu et al. (2023) on the pollution premium (who report a 4.42% annual pollution premium). It is most closely related to Barnett (2024), also a DSGE transition-risk model, but adds richer interactions among climate tipping, political risk, and technology breakthrough, imperfect energy substitution, and intrasectoral adjustment costs; Barnett instead emphasizes a climate-policy-driven ‘run on fossil fuel’. It provides a risk-based mechanism for the carbon premium documented empirically by Bolton and Kacperczyk (2021, 2023) and Hsu et al. (2023), while noting contrary evidence (Pastor et al. 2021; Bauer et al. 2022; Aswani et al. 2024; Zhang 2025 — who finds the premium turns negative in the U.S. after a data-lag correction; Hambel and van der Sanden 2024). Calibration of policy scenarios follows Moore et al. (2022).

What are the policy implications and their scope conditions?

Under policy transition risk, average climate policy is more ambitious than BAU but less ambitious than first-best; policymakers may set carbon taxes even higher than first-best to ‘catch up’ for time lost by predecessors when the economy is close to the temperature cap. Carbon premiums encourage firms to shift investment from brown to green and accelerate the transition. Scope conditions: carbon premiums are large only when the economy is still carbon-intensive (high brown-capital share) AND temperature is near or above the 2C cap; if policymakers implement first-best Pigouvian taxes while ignoring transition risk, the carbon premium is slightly negative. Physical-risk symmetry across sectors is assumed; if physical risk hit sectors differently there would be additional carbon-premium effects.

What happens to asset prices at the moment of each type of tipping?

At a tip to more ambitious carbon pricing, green share prices rise and brown share prices fall (and conversely when policy weakens). At a climate tip, both green and brown share prices fall (~3-5% each in the illustrative path). When negative-emissions technology becomes available, green prices jump down and brown prices jump up while the carbon price falls (because the brown sector may use fossil fuel again). The brown asset becomes worthless once the transition completes and the brown capital stock is run down; partial stranding occurs when the cap is crossed and fossil use is banned. News effects on prices are much larger for policy than for climate or technology tipping.

What drives the risk-free rate dynamics?

The risk-free rate (eq. 3.2) combines discounting, consumption-smoothing, standard diffusion and macro-disaster precautionary saving, an uninsurable temperature-risk term (small because consumption volatility is close to capital volatility, and it vanishes under CRRA), and a novel policy-transition-risk term that makes the rate jump with the policy state. Increased transition risk raises precautionary saving and lowers the rate, especially when temperature is close to its cap (where forced fossil phase-out makes expected consumption growth drop). As the transition completes and brown capital shrinks, precautionary saving falls and the rate stabilizes. Mean rate ~0.8%, stable; lower quantile falls over time.

Key Concepts

Policy transition risk: In this paper, the risk arising from stochastic, reversible jumps between discrete climate-policy regimes (no / modest / ambitious carbon pricing), modeled as a Markov chain with given or partly endogenous transition intensities — distinct from fixed NGFS-style scenarios. Financial markets price these regime-change risks even in the BAU state.

Carbon premium: Defined as the difference between the brown and green risk premiums (r^p_2 minus r^p_1). In the model it is a purely risk-driven, endogenous object arising because policy/temperature shocks hit the carbon-intensive brown sector’s price-dividend ratio more than the green sector’s; it is large near the temperature cap and slightly negative under first-best pricing without transition risk.

CAP policy state: The ‘ambitious carbon pricing’ regime in which policymakers set the carbon tax to internalize warming damages AND enforce a hard temperature cap Tcap=2C; if the cap is breached, fossil-fuel use is forced to zero (F1=F2=0) and carbon prices exceed the usual social cost of carbon.

PIGOU policy state: The ‘modest carbon pricing’ regime (added in the extended 3-state chain) that internalizes all global-warming externalities, including risks of climate disasters and tipping, but does NOT impose a temperature cap — yielding lower carbon taxes than CAP.

TCRE (transient climate response to cumulative emissions): The proportionality coefficient (theta/vartheta) translating cumulative net emissions into temperature change; calibrated at 1.8 C/TtC in the core model and allowed to jump irreversibly to 2.1 and 2.4 C/TtC under climate tipping.

Temperature/transition risk premium: A positive risk premium carried by all risky assets stemming from physical climate risk (disasters and tipping) that rises with the level of temperature; distinct from the carbon premium, which is the brown-minus-green differential and is driven mainly by asymmetric policy-transition exposure.

Partial asset stranding: The situation when the temperature cap is crossed and fossil fuel may no longer be burned, so the brown sector — though still operable with renewables — loses the value of its fossil-based capital, causing the brown share price to fall.