“Death by a thousand cuts” - why climate risk isn’t priced in

 Riccardo Rebonato is professor of Finance at EDHEC Business School and EDHEC-Risk Institute and scientific director of the EDHEC Risk Climate Impact Institute. 

The EDHEC Climate Impact Institute launched in 2022 as a successor of the Business School's previous Risk Institute, indicating the importance the School has assigned to climate change as a material risk factor to the global economy. 

Much of the Institute's research output is now focused on assigning probabilities to different climate scenarios, a step which is crucial to investment decision makers, as Rebonato argues. 

Investors who wish to model for climate change already have different scenarios at hand, what is different about the Climate Scenario Analysis EDHEC is providing?

The quality of the IPCC sponsored SSP RCP scenarios is very high, they have been created by top academics, there is no question about it. The problem is that they were not created with investors in mind. They fall short of providing the information investors need. By design, they have been created without any probabilities attached to them at all.

If you are a regulator or a policy maker, you may want to apply a precautionary principle. However, if you are an investor, there is no right way to be wrong. If you are too conservative or too aggressive, the underperformance of your portfolio can be just as severe. What is missing are the probabilities for certain scenarios.

Investment regulators tend to look at the most extreme scenarios. In reality, this also means that they are looking at the least likely outcomes.

What we are trying to do is to associate an approximate probability to these different scenarios so that investors can make a call about what is an unlikely scenario and what is a clear and present danger. When it comes to making investment decisions, this is fundamentally important and it’s missing.

We are trying to talk as much as possible in the language of the SSP [Shared Socioeconomic Pathways]. For better or worse, they have become the benchmark so there is no point swimming against the tide but let’s try to complement the information that is available.

Another issue with the SSP scenarios is that they don’t give any idea on variability and the variability is huge.

Modern finance is centred around risk and reward. Risk means uncertainty in outcomes, by collapsing these variants to a single outcome, you don’t give investors the ability to judge the trade-offs they need to make between risk and return. We are providing scenarios which are as similar as possible to the SSP scenarios equipped with probabilities of occurrence and an idea of the uncertainty around these scenarios.

At the end of the day, all these complicated stories come down to assumptions about economic development, demographics and technological development so why not just model them?

How does this play out across different asset classes, for example, bonds might be impacted differently to equities?

That is a very good point. When the economy is doing badly, interest rates are going to be low, this is something we have seen in real life. This matters for fixed income, but it also matters hugely for equities because part of the valuation of a stock depends on the discount rate.

Whenever the Fed says something about cutting rates, markets respond sharply because the lower the discount rate the higher the value of debt. Assuming that rates will be cut when things go badly, that should help valuations. However, one must be very careful because there situations whereby the economy is in the doldrums, but central banks cannot cut rates, perhaps because of an inflationary shock or perhaps because levels of public debt are very high. These models make reasonable assumptions, but they have to be treated with a certain degree of circumspection because they do not capture all the elements of reality.

Are there specific asset classes where it is it particularly hard to estimate the impact and also where the impact of climate change has perhaps been underappreciated?

You don’t have to look very far. Equity markets do not seem to reflect any substantial adjustment for climate change. This would be consistent with either climate change not having any significant effect on the economy with it being a non-issue or with the idea that we are taking very effective action and would be able to control the effects of climate change. If either of these scenarios were not true, then I would find it surprising that equity valuations reflect climate change so little. This should be quite a lot more embedded in the prices than it is right now.

Let’s suppose we take abatement seriously. To do this properly, you need serious money put to the task. Where is the money going to come from? Is it going to come from taxation or from public debt? If it funded by public debt issuance, then all of the sudden you will get a knock-on effect on the prices of bonds because you keep on issuing debt. The effects could be pervasive.

Could this trigger a sudden market correction?

Lots of people ask me: is there going to be a Minsky Moment? I don’t think so. It is difficult to conceive a particular event like Lehman Brothers that could trigger it. What is more likely to happen is that over time, actual earnings, actual cashflows disappoint. It is going to be death by a thousand cuts. This more likely to be a headwind for equities in the years and years to come. The unexpected impact of climate change will erode profitability. Most likely, this will be a serious of not catastrophic, but continuously negative surprises. While that may look tame, it is insidious. When you have a big shock like Covid, you get a massive fall of equities but then a rebound. Here, there is no mechanism for a rebound.

Isn’t the energy transition also a massive opportunity? There are going to be sectors that will benefit?

Yes, but I am taking the perspective of an investor with a globally diversified equity portfolio. You might get the clever person who has picked the right sectors, good for her, she is cleverer than me. But the first question is, how are equities as an asset class going to perform? I can see very plausible situations where there is going to be an impairment to cashflows which is not reflected in prices at the moment. Some sectors might escape this and do very well but other sectors will do even worse, these considerations are for the equity market as a whole.

So you would say equity markets as a whole are overvalued?

Indeed and just to recap, it is important to stress the role of interest rates in equity valuations, that is a key aspect in valuing stocks. Think of the rally that began in equities since 2009, that was not driven by an incredibly rosy horizon, equities were rallying because interest rates were being slashed. And when there was no more room to cut rates, they began to do quantitative easing. The effect of interest rates on equities is huge.

If there is room for central banks to counteract the economic downturn due to climate change by cutting rates, this could be very supportive for equities, the problem is that this assumes there are no other surprises on the horizon. No Ukrainian war, no Covid..

And no inflation?

Exactly. Inflation is not normally associated with economic distress but you can have situations where we had this stuttering economy and inflation, a stagflationary situation, from a central banker’s perspective, that is really bad.

The other thing I would add: Don’t expect that climate change is only going to impact the obvious assets. The channels through which climate change can impact different asset classes are multivarious, subtle and not obvious. There has been a study by the IMF which considers the cost of abatement, either we are going to raise taxes or raise a lot of debt, there is little room for either.

If public debt were to go up by 40% to fund our response to climate change, this will have an impact beyond treasuries. Consider the impact of quantitative easing, the purchasing if bonds, which had impacts on every asset class. This is something one has to think about, understanding the links and probabilities will be crucial.

This means the impact of climate change on bonds is also underestimated?

Yes, especially treasuries of countries that do not have a lot of fiscal headroom, The US can take a lot on the chin, Italy can’t. It is not so much the debt to GDP ratio which is very country specific, Japan’s debt to GDP is huge but people are taking it in their strides, not so much in Italy.

This is not an argument to not fund the transition. The physical risks and the transition risks operate more or less as a seesaw, the less you spend on abating climate change the bigger the physical risks become. This is why physical risks and transition risks have to be looked at in the same breath.

So how can asset owners respond to this at portfolio level?

When you communicate the information, every portfolio manager can make their own decisions based on their appreciation of relative asset classes, benchmarks and mandates. The important thing is that the decision makers should be provided with the full information. It is not for me to provide investment advice. I have been on the buy and on the sale side, but that is not my job now, my job is to provide information which helps investors to decide how they should adjust their portfolio. Quite frankly, if I think there is going to be a headwind in equity valuations, I might trim my equity exposure in a diversified portfolio, this is more of an asset allocation decision rather than a stock picking decision for the asset owner. In any case, I am providing the information as best as I can, and it is up to investors whether to act on it.

Are we getting to a point where this sort of information is being taken more seriously?

There is a desire for this sort of information but the information that is available now is not suitable for investors, that is precisely what we are trying to rectify.