Lionel Melin & Fangyuan Zhang (ECI): "Our results are closer to practitioners’ needs and provide a tractable way of translating climate science into interest rates and equity risk premia"

While extreme weather events dominate the headlines, the slow and persistent rise in global temperatures is quietly reshaping how markets price long-term risk. In their working paper Quantifying Climate Risk Premia (1), published earlier this year, Lionel Melin, Associate Researcher at the EDHEC Climate Institute, and Fangyuan Zhang, Senior Research Engineer at the EDHEC Climate Institute, examine how physical climate risks and transition costs affect interest rates, equity risk premia and asset values. In this conversation, they explain why investors may demand higher returns to compensate for climate-fueled uncertainty, and why slow-moving climate change can affect markets today.

For starters, what is a climate risk premium?

Lionel Melin: Put it simply, it is the extra return investors demand to compensate for the financial risks introduced by global warming, a sort of financial buffer. Extreme weather, lower agricultural productivity or the cost of transitioning to green energy can threaten long-term economic growth. Investors then perceive financial assets as riskier and require a higher expected return to hold them.

This matters because required returns and asset prices move in opposite directions. When the climate risk premium rises, valuations fall. Climate risk is therefore an additional layer on top of the risks investors already know how to navigate.

What does your framework add to existing research on the topic?

Fangyuan Zhang: Previous approaches often treated climate-related risks separately. Some models focused on acute physical risks, such as disasters or tipping points, while others concentrated on transition costs. Our framework puts physical and transition risks into the same asset-pricing model, because investors face both at once.

We also shift the focus towards chronic physical risks: gradually rising average temperatures and changing precipitation patterns. Their effects on economic growth and cash flows may be gradual but persistent and therefore affect long-term investment returns.

Our model is calibrated using empirical damage estimates and benchmark climate scenarios, including those developed by the Network for Greening the Financial System. This brings the results closer to practitioners’ needs and provides a tractable way of translating climate science into interest rates and equity risk premia.

Why can chronic risks raise the premium without a disaster?

Fangyuan Zhang: The underlying mechanism works through expected consumption growth and uncertainty. Chronic climate change can reduce long-run consumption growth, with persistent effects not only on current output but also on expectations about future growth. Investors therefore perceive future cash flows as riskier.

If climate change also makes future growth more volatile or harder to predict, they will demand a higher return. Persistent damage to growth, combined with greater uncertainty, is already enough to make risky assets less attractive, even without disasters or catastrophic tipping points.

Lionel Melin: This is why our model needed to take a genuinely long-term perspective. We follow the transition dynamics through the end of the century and beyond, as temperatures move towards some form of stabilisation in very different possible scenarios. Over such horizons, even moderate variability can generate large divergences. Slow-moving effects can therefore be reflected in asset prices today. Acute events such as heatwaves may also be highly disruptive. But they are not the main ingredient in this version of the model.

What are the main results revealed by your model?

Lionel Melin: In a scenario where the global temperature reaches about +3°C above pre-industrial levels by 2100, the equity risk premium rises by roughly +20% compared with a counterfactual world without climate change. This additional required return is so large that it should imply substantial changes in market prices.

The expected risk-free rate falls during periods of rapid warming because growth slows. But the increase in the equity risk premium is larger. Expected equity returns therefore rise overall, which can translate into lower asset values today.

How can different stakeholders use the framework?

Lionel Melin: Climate change is unprecedented, so historical data alone cannot provide the reference points decision-makers usually rely on. We need forward-looking frameworks.

Investors can assess how physical and transition risks may alter their portfolios and asset values. This can help them anticipate changes in market prices and determine the compensation they require. The framework is particularly relevant for long-term investors such as pension funds and sovereign wealth funds.

Regulators and policymakers can compare current-policy and decarbonisation scenarios through a financial lens. The model clarifies the trade-off between the cost of mitigation and the risk of financial instability if warming is not mitigated.

For companies, a higher equity risk premium means a higher cost of capital. Financing operations and investment becomes more expensive, while equity valuations come under pressure. Something to anticipate!

What are the current limitations to your model and what could be the next steps?

Fangyuan Zhang: The model is deliberately reduced-form, meaning that it simplifies the way climate channel is represented rather than reproducing the full physical dynamics of the climate system. This allows us to obtain closed-form solutions and calibrate the model properly.

It currently focuses on rising average temperatures and is designed to capture first-order impacts. It should therefore be seen as a baseline model that makes the link from climate scenarios to economic growth and financial markets transparent and accessible to practitioners. Its simple form is deliberate, but it is also its limitation.

Lionel Melin: One possible extension concerns regional heterogeneity, because climate damages will not affect every country—or every region within a country—in the same way.

Another is to add acute risks and tipping points to a framework that currently focuses on chronic risks, gradual warming and persistent effects. We are working on ways to incorporate this type of disaster risk.

A third direction would be to incorporate feedback from policy responses, technological change and adaptation. As climate risks become more visible, behaviour will change. Capturing these responses would make the framework richer and closer to real-world decision-making.

References

(1) Quantifying Climate Risk Premia (March 2026). EDHEC Climate Institute working paper. Lionel Melin, Fangyuan Zhang - https://climateinstitute.edhec.edu/publications/quantifying-climate-risk-premia