The economic effects of climate change may be substantial and may unfold over the upcoming decades. Therefore, climate change can affect the future payoffs of a wide range of assets. Given this strong potential impact, a question arises; do markets do a good job of reflecting climate risk in asset prices? – as some worry that markets might struggle to incorporate information about climate risk.
“Financial markets assess many complex & uncertain events every day.”
Let’s not forget, however, that financial markets assess many other complex and uncertain events every day. Examples include the potential changes in consumer demand and business practices after the pandemic, the impact of current stimulus spending on future inflation, the evolution of international political and trade relations, and the impact of technological innovation.
Since the pioneering work of Fama et al. (1969), academic research has shown that financial markets are remarkably good at processing new information. Thanks to intense competition among many market participants globally, prices quickly reflect news about the economy, scientific advances, and geopolitical developments. Thus, when comes to climate risk there is no exception as research shows that prices in a variety of asset markets incorporate information about climate risk.
Pricing of Physical Risk
Physical risk refers to the direct effects of climate change; a coastal property exposed to increased flooding risk would be an example. In the real estate market, houses exposed to sea level rise sell at a 7% discount to properties with similar characteristics. Interestingly, most of the discount is driven by houses not at risk of being flooded for another 50 years. Even in decentralized, less-liquid markets such as real estate, there is evidence that prices reflect long-run climate risk.
Pricing of Transitional Risk
Transitional risk arises because of the uncertainty surrounding the transition to a low-carbon economy. There is uncertainty, for instance, around both the timing and scope of new environmental regulations. As a result, firms whose business models depend on high fossil fuel use are likely to have high exposure to transitional risk.
For instance, 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). The latter paper argues that most fossil fuel reserves would need to remain untouched if warming is to be kept under 2°C by 2050; for comparison, the objective under the Paris Agreement is to limit all future warming at 2°C, an even more stringent objective. Therefore, most reserves would become worthless under aggressive mitigation policies. Consistent with the idea that asset prices reflect climate risk, markets reacted in the three days following the publication of the article in 2009, although the article was only publicized by the press a few years later.
All these studies suggest that asset prices reflect the potential impact of climate policy or changing consumer tastes.
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 climate risk. This pattern is consistent with the behaviour we would expect in competitive markets: buyers and sellers have incentives to use all the information at their disposal to value assets, and the literature suggests that information about climate change is no exception.
Financial markets pay attention to climate risk despite its complexity. Moreover, competitive market forces provide firms with incentives to better manage their exposure to climate risk to reduce their cost of capital.
Veronika Holubova (MFinP, GradCertFP, ADFP, DipFP) is an Authorised Representative of Alman Partners Pty Ltd, Australian Financial Services Licence No: 222107.
Any information provided to you was purely factual in nature. It has not been taken into account your personal objectives, situation or needs. The information is objectively ascertainable and is not intended to imply any recommendation or opinion about a financial product. This does not constitute financial product advice under the Corporations Act 2001 (Cth). It is recommended that you obtain financial product advice before making any decision on a financial product such as a decision to purchase or invest in a financial product. Please contact us if you would like to obtain financial product advice.
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