Mental Models in Financial Markets: How Do Experts Reason About the Pricing of Climate Risk?

We study how financial experts reason about the pricing of climate risk and how these beliefs shape return expectations. Using a survey of CFA-certified professionals, we document substantial disagreement about whether climate risks are currently under- or overreflected in equity prices, why such pricing deviations arise, and how persistent they are expected to be. Analyzing open-text responses, we identify distinct mental models professionals use to think about climate-risk pricing, including informational frictions and second-order beliefs about other market participants. These mental models explain economically large differences in expected returns for climate-resilient versus climate-exposed firms: the spread in expected long-run annual excess returns across mental models exceeds 3.8 percentage points. Mental models vary systematically with experts’ political orientation and geography. Finally, an information experiment demonstrates that second-order beliefs causally affect return expectations. Our findings identify mental models as a microfoundation of heterogeneous expectation formation in climate finance.