A Dollar & (Climate) Change
We are like tenant farmers, chopping down the fence around our house for fuel, when we should be using nature’s inexhaustible sources of energy — the sun, wind, and tide.
You may not be that interested about how climate change is affecting the world today, but perhaps you’d want to hear about the direct impact it has on your money. The economic effects of climate change may be substantial, unfolding over decades, and can affect the future returns of a wide range of assets.
An important question to consider is whether markets do a good job of reflecting the climate risk in the prices of stocks and bonds. Since the effects of climate change are uncertain and potentially long-lasting, investors may struggle to incorporate that information as quantitative risk. However, financial markets assess many other complex and uncertain events every single day. Everyday investors are trying to estimate potential changes in consumer demand and business practices after the pandemic, the impact of current stimulus spending on future inflation, how political and global trade may evolve, and the impact of technology on the world.
Nobel prize winner Eugene Fama’s 1969 paper and subsequent academic research has shown that financial markets are remarkably good at processing new information. Thanks to intense competition among global investors and traders, prices quickly reflect news about the economy, scientific advances, and geopolitical developments — and climate risk appears to be no exception. Recent research shows that prices in a variety of asset markets do incorporate this information.
So how does the price of assets change in respect to climate risk? The first component of risk to consider is physical risk; which refers to the direct perceptible effects of climate change. A coastal property exposed to increased flooding risk would be an example. Research shows that municipal bonds offer an interesting setting to study exposure to physical risk, since, municipalities cannot relocate to avoid the physical effects of climate change. The study finds that higher exposure to sea level rise is associated with higher municipal bond yields. The real estate market offers another important source of evidence. Buildings are also impossible to relocate and are exposed to physical risk. Research found that houses exposed to sea level rise sell at a 7% discount as compared to properties with similar characteristics.
The second component is transitional risk; there is uncertainty around both the timing and scope of new environmental regulations and the transition to a low-carbon economy. As such, firms whose business models depend on high fossil fuel use are likely to have high exposure to transitional risk. Research found that the stock prices of the 63 largest US oil and gas energy firms fell by 1.5% to 2% after the publication of a landmark paper in Nature (Meinshausen et al., 2009) - where the author discovered that most fossil fuel reserves would need to remain untouched if warming is to be kept under 2°C by 2050. As one of the objectives of the Paris Agreement is to limit all future warming to 2°C, most oil and gas reserves would become worthless under aggressive mitigation policies.
Research conducted in 2014 that found that firms with negative environmental externalities faced a higher cost of capital, whilst this 2019 paper contended that fossil fuel firms incur higher interest rates on syndicated bank loans. In both cases, the mechanism in question is related to potential regulatory or reputational risk, rather than the direct effect of global warming on firm performance.
Overall, a growing body of evidence shows that prices across many different markets (stocks, bonds, climate futures, equity options, and real estate) incorporate information about the climate risk. These results are also encouraging for everyone concerned about climate change. Financial markets seem to pay attention to climate risk despite its complexity and investors will do well to note that achieving long term sustainable results requires some level of awareness of the world at large.
