There is no single risk factor that can correctly encapsulate the complexity of global climate change, says Charles Donovan
The investment community has finally woken up to the issue of climate change over the past 18 months. The recent spike in concern is well justified, having occurred after a slow learning process over the past couple of decades.
There is broader recognition these days that the world is on course to become 3-4ºC warmer within our children’s lifetimes. And that’s just the average. In the far northern and southern latitudes, changes of that magnitude will happen before my kids finish university. The aspiration for 2ºC of warming set down in the UNFCCC Paris Agreement 2016 might indeed be just a fantasy.
Perhaps that’s why, ahead of regulatory standards, institutional investors and their asset managers are seeking to manage exposure to climate risk. In a world that is proving inept at collecting the low-hanging fruit – complete decarbonisation of the global power sector – and has few answers for how to cost-effectively eliminate greenhouse gas from other economic sectors, such as shipping, airlines, chemical feedstocks, and industrial smelting, a focus on climate risk would seem prudent. But what is climate risk exactly?
I argue there really is no such thing as climate risk, because there is no single risk factor that can correctly encapsulate the complexity of global climate change. There is no such thing as climate risk because there is no single way to describe it.
The concept of climate risk straddles at least two distinct categories of risk: physical and transitional. The first is a bundle of the real-world manifestations of global warming, while the second attempts to capture a broad range of technological, political, and social changes related to a lower-carbon global economy.
Some industries are highly sensitive to transition risks. German utilities, for example, have suffered deep financial distress triggered by the deflationary effect of the high-penetration of solar power and wind-generated electricity.
On the other hand, real estate investors are likely to find that it is long-term physical impacts that matter most. Extreme weather conditions (flooding, storms, and droughts), and climatic trends (sea level rises, extreme temperatures, and ocean acidification) generate a complicated layer of possible economic loss. There’s really no intelligent way to estimate these generically. Investors will have to work their way through the specific exposures of individual assets.
One would expect rating agencies such as Standard & Poor’s (S&P) and Moody’s, whose role in the capital markets is to assess risk, to be aware of the risks posed by climate change. Indeed, Moody’s and S&P have published commentaries on how they integrate climate factors into, for example, sovereign bond ratings. Yet there has been no rating action taken by S&P or Moody’s in which climate risk was named as a material contributing factor to a sovereign bond rating decision. Such is the case not just in sovereign bonds, but across asset classes. There sure is a lot of smoke, but so far it’s been tough to find the fires.
The ultimate quest of many researchers has been to place climate risk within a multivariate asset-pricing model framework that would indicate the correct rate of financial return required to compensate investors for bearing this risk. Hence the push by the Bank of England and other central banks for disclosure of climate risks that would promote price discovery. But until we get away from a single notion of climate risk, I believe this effort will fail.
That’s not to say that changes are not occurring in asset pricing – and as expected, it’s the debt markets where the action shows up first. But it will be impossible to arrive at a single figure that could ever capture the highly heterogeneous set of variables that constitute climate risks. There is a view among regulators that transition risk might be mispriced in financial markets and could, therefore, become a threat to financial stability. But so far, empirical evidence has not come forward that demonstrates the pricing impacts of transition risk in listed markets, much less the less transparent unlisted world. That doesn’t mean that people aren’t trying – and making money from taking positions informed by small signals in the data.
Over the past century, the frequency of natural disasters has increased significantly, as has their economic impact. The occurrences of climate-related natural disasters are predicted to rise as temperatures increase, with the prospect of systemic impacts on economic growth. That doesn’t necessarily mean that climate change is a systemic risk factor, but nor does it imply that these risks can be diversified into thin air.
A year ago, Imperial College Business School launched a new research centre with the goal of generating a robust evidence base about the impact of climate risks on financial markets. We will be releasing a MOOC (massive open online course) on managing climate risks and capturing new opportunities on edX in July.
In the interim, what are real assets investment managers to do? If you’re lucky, climate risks might play out in your portfolio as nothing more than inflating insurance premiums. But others, particularly those who choose to be ignorant about the future, face losses from market shifts and asset price corrections. To date, valuation impacts have been most pronounced in the energy sector but will affect other types of real assets over time.
While the physical and transitional risks associated with climate change really are apples and oranges, there is, in principle, a relationship. To the degree transitional measures don’t bite, the physical manifestations of climate change will get worse. As the realities of climate change become more evident, transitional measures become more likely. Taken together, climate change is clearly a downside risk. As an engine of creative economic destruction, it will create many winners and losers. But this is not a game of chance; the net payoff is not zero.
Those of us who have based our careers on trying to understand the notion of risk are typically enchanted by games of probability. While I try my best to stay away from the addiction of betting these days, I’ve kept with me an enduring bit of advice. There’s goes a saying at the poker table that if you don’t know who the sucker is, it’s probably you. If like me, you don’t buy into the current rhetoric about climate risk, that’s fine. Investors will, of course, continue to innovate new ways of measuring and trading risk exposures associated with climate change. Just don’t let that ‘no-thing’ called climate risk make you the next sucker.
Charles Donovan is director at the Centre for Climate Finance and Investment, Imperial College Business School
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Opinion: There’s no such thing as climate risk