Companies that are more sensitive to temperature changes are consistently overvalued and deliver lower-than-expected returns.
Global temperature rises as a result of climate change impact firms differently, with sectors such as agriculture and energy directly exposed to physical climate risks, while others face transition risks linked to regulation, supply chains and consumer behaviour.
A new study published in Management Science analysed more than five decades of US stock data and introduced a new measure of 'temperature sensitivity' to assess how companies' stock returns respond to unusual temperature shifts.
The international team of researchers, including from the University of Exeter Business School, compared temperature deviations from long-term monthly averages with firm-level stock performance to identify how sensitive each company is to climate variation.
They found that companies whose performance is more affected by temperature changes are less profitable, pursue riskier business strategies and generate lower stock market returns than expected.
However, these same firms retained a high stock price, which suggests the financial impact of rising temperatures is being underestimated.
The researchers found that local investors that were familiar with firms' regional conditions were more likely to price-in temperature-related risks than non-local institutional investors.
Sell-side equity analysts also appeared to misjudge the impact of temperature, with earnings forecasts for high temperature-sensitive firms less accurate.
The researchers found that a trading strategy that bought stocks of low-sensitivity firms and shorted high-sensitivity ones generated an annualized, risk-adjusted return of 4.1% over the 52-year sample period.
Professor Chendi Zhang from the University of Exeter Business School and Director of the Exeter Sustainable Finance Centre said: "While there is broad consensus about the potential impact of climate change and carbon emissions on firms, surprisingly little has been done to quantify systematically the economic impact of temperature changes for individual firms.
"Our novel, firm-level, market-based measure of temperature sensitivity, which utilizes public information available for an extended time period, fills that information gap and our results show that traditional valuation models do not capture how climate change-induced temperature changes are directly affecting firm performance - despite growing investor attention to climate resilience and environmental sustainability."
The researchers, including Dr. Wei Xin and Prof. Chendi Zhang from the University of Exeter Business School, argue that their temperature sensitivity measure, which is based on publicly available data, is a practical tool for investors, analysts, and policymakers seeking to better assess climate-related financial risks.
