Transition risk, physical risk, and the realized volatility of oil and natural gas prices

Abstract

The climate change-related risks have been classified into two namely physical risk and transition risk based on the losses suffered and the response to mitigate and adapt to the paradigm shift in environmental sustainability. Consequently, we test how much predictive value can be exploited from these components of climate risks if they are observed in the pricing of energy commodities that are known to be among the largest emitters of emissions. We note three findings in our empirical analyses in this regard. First, we establish that climate risk influences the volatility of crude oil and natural gas markets and improves their out-of-sample forecasts. Second, the transition climate risk more accurately predicts the out-of-sample forecasts of energy market volatility than the physical climate risk suggesting that investors respond more to the various policies/programmes/initiatives aimed at mitigating the climate change-related losses and fatalities and adapting to the paradigm shift in environmental sustainability than paying attention to the physical damages associated with climate change. Finally, investors are more likely to derive higher economic gains when climate risk is observed than when it is not and the outcome from transition risk is greater than that of physical risk. We further highlight some implications of our findings for investors and policy makers.