We exploit regional variations in exposure to heat stress to study if physical climate risk is priced in municipal and corporate bonds as well as in equity markets. We find consistent evidence across asset classes that local exposure to heat stress is associated with higher yield spreads for bonds, especially for lower-quality and longer-maturity bonds, as well as higher conditional expected returns for stocks. These results are observed robustly starting in 2013–15, and are consistent with macroeconomic models where climate change has a direct negative impact on aggregate consumption.

This paper analyzes how climate risks are priced on financial markets. We show that climate tipping thresholds, disagreement about climate risks, and preferences that price in long-run risks are crucial to an understanding of the impact of climate change on asset prices. Our model simultaneously explains several findings that have been established in the empirical literature on climate finance: (i) news about climate change can be hedged in financial markets, (ii) the share of green investors has significantly increased over the past decade, (iii) investors require a positive, although small, climate risk premium for holding "brown'' assets, and (iv) "green'' stocks outperformed "brown'' stocks in the period 2011--2021. The model can also explain why investments to slow down climate change have been small in the past. Finally, the model predicts a strong, non-linear increase in the marginal gain from carbon-reducing investments as well as in the carbon premium if global temperatures continue to rise.

Carbon-intensive firms have been underperforming in the U.S. despite their higher carbon transition risk. The brown-minus-green return spread, or carbon return, is zero on average globally but varies significantly across countries with unexpected cash flow shocks and climate taste shifts. The lower carbon return in developed markets reflects stronger growth in climate concerns instead of a lower expected carbon return. Additionally, countries with civil laws, more renewable energy, and tighter climate policies exhibit higher carbon returns. The inference differs from previous studies because I relate stock returns to lagged carbon measures, avoiding the issue of forward-looking bias.