How Climate Risk Affects The Financial System
By Afreen Shafeeque
As the effects of climate change have become ever more prominent in modern times, their impact on financial markets has also become more evident. Climate change imposes financial risk which can be sorted into two main categories - physical and transition risks. Physical risk refers to the direct costs of climate-related events such as hurricanes, droughts, and forest fires. This includes potential damage to infrastructure, production facilities, and the health and productivity of workers impacted by these events. Transition risk refers to the risk that investors may bear as the economy transitions to being more climate-friendly and certain sectors (such as carbon-heavy industries) become more redundant. Although a lot of information regarding climate risk is publicly available, a significant body of research suggests that climate risk is not factored in sufficiently by financial markets (Merten and Verhoeven 2022). Different categories of financial assets may be impacted by climate change in different ways, with winners and losers. However, there is also a broad systemic risk due to the uncertainty regarding how climate change will evolve and its potential wide-ranging effects.
Why is it important for financial markets to correctly account for climate risk?
Physical and transition risks impose a threat of negative financial and economic shocks. Climate-related disasters can wipe out large amounts of capital and sever the productivity of workers. These physical costs and the uncertainty regarding how climate change will evolve also impact investors' expectations on the valuation of assets and certain industries which can trigger financial and stock market instability. Therefore, assessing climate risk is important for both governments and investors to dampen the negative economic effects of climate change and build the resilience of our financial systems.
Why have financial markets not sufficiently priced in climate risk?
Despite the continuously growing information regarding climate change, research suggests that financial markets have not sufficiently priced in climate risk as would have been expected. There are several potential reasons for this. To begin with, climate change is a time-variable risk. Although we have learnt a lot about this phenomenon over the past few decades, climate change is a complex phenomenon which we are continually learning about. Additionally, based on our current and future responses to future change, the risk of climate change may change over time. However, through the development of quantitative environmental measures, accessible data and research and the growing awareness of climate change this can be expected to improve.
Another reason may be that traditional asset pricing models may not be capable of properly depicting the sensitivity of financial assets to climate risk as well as the broad systemic risk of climate change. Hence, we may require the development of better financial models.
Financial measures and the impact on different asset classes
Due to the aforementioned reasons, investors and researchers are interested in developing methods to account for the climate risk of investments. One such example is the “carbon beta” (Huij et al, 2021). This provides a measure of how an asset’s return is correlated with climate risks such as climate events or concerns regarding the environment. This helps identify which assets may benefit from a low-carbon transition and which assets may be negatively impacted as more environment-related events manifest.
It would be expected that assets or equities related to high emissions, would be more affected by climate risk. However, an interesting finding is that companies with similar levels of carbon emissions have different carbon betas. For example, Tesla and W&T Offshore (oil and gas company) have similarly high carbon emissions. However, Tesla’s stock responds significantly less negatively to climate risk (Huij et al, 2021). This suggests that solely carbon emissions may not accurately represent the exposure of assets to climate risk, but also that investors' expectations of a company’s climate risk exposure need to be factored in.
Different types of assets are also affected by climate risk varyingly. For example, government bonds and equity related to countries closer to the equator are more exposed to climate risk. Furthermore, government bonds of more climate-risk exposed countries may be more fixed compared to stocks as companies can diversify their locations to less climate-risk exposed regions.
The future
The essential factor for accurately pricing climate risk is transparent and accurate data as well as the development of better quantitative measures. A survey of leading firms by the European Central Bank shows hopeful results that two-thirds of the companies mentioned transition risks and half of the respondents mentioned physical risks when assessing the main impact of climate change on their companies (Kuik et al, 2022). Finally, the importance of accounting for climate risk may need supporting policies such as data transparency and public disclosure policies.
Bibliography
Acharya,V., Johnson,T. ,Sundaesan,S and Tomunen,T. (2022). Is Physical Climate Risk Priced? Evidence from Regional Variation in Exposure to Heat Stress. CEPR Press. Discussion Paper No. 17516. https://cepr.org/publications/dp17516
Huij, J., Laurs,D., Stork,A and Zwinkels,R. (2022) Carbon Beta: A Market-Based Measure of Climate Risk. Available at SSRN: http://dx.doi.org/10.2139/ssrn.3957900
Kuik, F., Morris,R and Sun,Y. (2022) The Impact of Climate Change on Activity and Prices- Insights from a Survey of Leading Firms. European Central Bank. ECB Economic Bulletin, Issue 4/2022. https://www.ecb.europa.eu/pub/economic-bulletin/focus/2022/html/ecb.ebbox202204_04~1d4c34022a.en.html
Merten,F and Verhoeven,N. (2022). Pricing of Climate-related Risk in Financial Markets. DeNederlandscheBank.https://www.dnb.nl/media/dvpdrakl/pricing-of-climate-related-risks-in-financial-markets.pdf
Woetzel,J., Pinner,D., Samandari,H., Engel,H., Krishnan,M., Boland,B and Powis,C. (2020) Climate Risk and Response: Physical Hazards and Socioeconomic Impacts. McKinsey Global Institute.Pmckinsey.com/capabilities/sustainability/our-insights/climate-risk-and-response-physical-hazards-and-socioeconomic-impacts