Climate Stress-Tested Factor Models: Extending Asset Pricing with ESG Risk
DOI:
https://doi.org/10.64137/31080030/IJFEMS-V1I2P102Keywords:
Asset pricing, Climate risk, ESG factors, Factor models, CAPM, Fama-French, Carhart, Climate stress testingAbstract
The financial market increasingly understands the climate challenge and ESG, or environmental, social, and governance, considerations, which have been disrupting traditional aspects of asset pricing and financial risk management. Standard factor models. Systematic risk premia and asset returns have long been explained by classical factor models, including, but not limited to, the Capital Asset Pricing Model (CAPM), the Fama-French three-factor model, and its extensions. Nevertheless, such models are not particularly sensitive to ESG and climate-related threats, which are becoming more important to investors and regulators alike. This paper represents a new addition to existing factor pricing approaches since the risk variables of ESG are included directly in asset pricing models and are put through a climate stress-testing variety analysis. Precisely, the study incorporates climate-related financial variables like carbon intensity, ESG score and exposure to green bonds in the traditional Fama-French and Carhart models. The study bridges a considerable gap in academia and fieldwork. The present literature has studied the ESG factors qualitatively or has investigated their relationship with the firm-level performance, yet they have not incorporated or integrated such risk into traditional asset pricing models. Regulators, Concurrently, regulators including the European Central Bank and the Bank of England, are increasingly requiring climate stress tests, indicating that, compared to academia, the financial community is catching up in ensuring accounting with distinction. The paper aims to fill that gap, developing a basis in econometric theory of climate-aware asset pricing
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