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HOW ARE MARKETS PRICING IN CLIMATE RISK?

Weathering Climate Change | Chapter 3

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CLIMATE RISK IS – AND WILL INCREASINGLY BE – REFLECTED IN MARKET PRICES

It is no longer a matter of if this repricing will occur. Rather the real question is whether this repricing will be an orderly one ushered in by regulators and gradual market adjustments, or an abrupt, sharp decline in market sentiment triggered by a series of localized climate “Minsky moments.” Regardless of the trajectory, the implications across investors’ portfolios will be immense.

When climate change is perceived to have reached a tipping point

There have been enough obvious climate change-driven anomalies and disasters that market participants can no longer ignore them. The 2020 Atlantic hurricane season, for example, has produced more named storms than any prior season.¹ The historic 2020 wildfires in California scorched more than 4 million acres, doubling the previous record.²

Better disclosure and analytics drive a data revolution

According to a PGIM survey of global CIOs, more than 40% do not currently incorporate climate change into their investment process. Availability of reliable modeling around the market impact of climate was the most cited hurdle. Fortunately, climate analytics and modeling are finally emerging from academic articles and becoming more accessible for investors. Indeed, the last few years have seen the beginning of what could be called a “data revolution” around climate analytics. While still in its early stages, this trend allows investors to better quantify climate risk and differentiate between firms within an industry, despite the limited quality and consistency of climate data today. This kind of relative valuation tends to lead to a gradual repricing of assets.

Policy and regulatory initiatives drive market-pricing of carbon

Europe’s emissions trading system (ETS) led to a significant repricing of European utilities. Clearly, this type of government action can play a key role in altering the economics of carbon-intensive assets. Such changes in policy and regulatory regimes can be catalysts for a broader market repricing. As more jurisdictions adopt comparable policy initiatives, a more complete repricing of transition risk is likely to occur globally.

Shifting sentiment of investors and consumers

Changes in the preferences of investors and consumers can also catalyze repricing of climate risk. In the case of investors, more than $40 trillion is currently invested in ESG strategies globally.³ While not all of that is geared towards the “E” component, it is nevertheless telling that some investors already consider climate-related risks and carbon emissions to be material and relevant for them. In order to compete for capital, firms must respond to changing investors’ preferences or risk relying on a shrinking pool of potential investors and facing a higher cost of capital.

Corporate climate liability

Another potential avenue for the repricing of carbon-based assets is through the courts. To date, no legal challenges against carbon-emitting companies have succeeded in their attempts to seek damages for harm done to the climate – but this field is still evolving. Of the roughly 1,500 climate cases filed, the vast majority were in the last decade.⁴ And with new lines of attack constantly being explored, it’s plausible that at some point one of them will succeed.

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Climate change is a slow-burning issue with indiscernible impacts on a year-to-year basis but potential for exponential growth once tipping points are reached.

Page 24, Weathering Climate Change

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<p>Climate change is a slow-burning issue with indiscernible impacts on a year-to-year basis but potential for exponential growth once tipping points are reached.</p>
  1. Machemer, Theresa, “The 2020 Atlantic Hurricane Season Officially Has the Most Named Storms on Record,” Smithsonian Magazine, November 11, 2020. 
  2. Stelloh, Tim, “California exceeds 4 million acres burned by wildfires in 2020,” NBC News, October 4, 2020.
  3. Baker, Sophie, “Global ESG-data driven assets hit $40.5 trillion,” Pensions & Investment, July 2, 2020.
  4. Setzer, Joana and Byrnes, Rebecca, “Global trends in climate change litigation: 2020 snapshot,” Grantham Research Institute on Climate Change and the Environment, Columbia Law School Center for Climate Change Law, and Centre for Climate Change Economics and Policy, July 2020.