Are Markets Asleep at the Wheel? Riccardo Rebonato Scientific Director, EDHEC-Risk Climate Impact Institute Professor of Finance, EDHEC Business School 1 Outline of Presentation 1. Plan of the Session 2. Statement of the Problem 3. Do Prices Respond to Climate Shocks? 4. Are Climate Outcomes Price-Relevant? ➢ Does Unmanaged Climate Risk Matter for Asset Prices? ➢ Will Climate Risk Be Successfully Mitigated? 5. An Optimistic Estimate 6. A Bit of Theory 7. Conclusions 2 Plan of the Session ▶ A large number of studies have failed to date to identify a robust and economically significant climate risk premium or climate beta, either at the aggregate or at the sectoral level. ▶ How can this be the case? ▶ I intend to argue that a mispricing of climate risk is the most likely explanation. ▶ If this is true, price adjustments will eventually occur, either in a gradual or in an abrupt way. ▶ This is a novel source of risk, which should be on the radar screen of long-term investors. 3 Statement of the Problem In a recent review paper Acharya (2023) argues that ▶ “[w]hile [the] literature has convincingly documented that climate risks are currently priced across a range of asset classes, much less is known about whether they are adequately priced. [This] is, however, an important question for assessing the likelihood of potentially substantial short-run asset revaluations as there might be strong [...] revisions in the price of risk associated with the inherently evolving nature of climate risk realizations. [...] ▶ If investors fail to [...] update beliefs in response to information about future climate risk realizations, this might reduce the average present-day effects of long-run physical climate risks [...]; ... , it could also lead to more substantial revaluation risk in case beliefs eventually move by a substantial amount”. 4 Statement of the Problem Why do we think that markets could be ‘asleep at the wheel’? ▶ First, attempts to detect a ‘climate beta’ (the sensitivity of different asset classes to climate shocks) have so far been met with mixed success at best: there is no universal agreement as to which asset classes have a positive or a negative climate beta, and the price sensitivity has always been found to be at the limit of detectability (of statistical significance). ▶ Economic significance is even more dubious than statistical significance. ▶ This suggests that, if prices have so far reflected climate information, they must have done so to a very limited extent. 5 Statement of the Problem ▶ Second, this muted sensitivity of prices to climate news is difficult to reconcile with the expected economic outcome of any climate policy: 1. 2. if we deal with climate change seriously, the transformation of the whole economy will have to be radical (with adaptation and abatement costs of the same order of magnitude as what we currently spend on education or defence); if the climate change problem is left untackled, temperatures on the planet are likely to reach levels never experienced by the human species – with potentially serious economic consequences. ▶ This is why the muted sensitivity of asset prices to climate innovations constitutes a puzzle. 6 Statement of the Problem What could the explanations be? These are the most likely possibilities: 1. 2. 3. 4. 5. the market is informationally efficient and has already impounded all the relevant information; the market is informationally efficient, but it expects the climaterelated cashflow impairment to be small for all sectors, even if no significant climate action is taken; the market is informationally efficient, but it is confident that the climate-related cashflow impairment to be small because it believes that climate risk will be effectively managed – eg, the temperatures will remain within the Paris Agreement 1.5-2 C target; the market is informationally efficient, believes that climate damages will be significant, but these damages occur so far in the future that they are effectively ‘discounted away’. the market is ‘asleep at the wheel’, by which we mean that the prices do not correctly reflect expectations and uncertainty about climate outcomes. 7 Do Investors Believe in Climate Change? Figure 1: Breakdown of political affiliations for beliefs about climate change. Figure 2: Breakdown of political affiliations for beliefs about climate change. 8 Do Investors Believe in Climate Change? Figure 3: “The effects of climate finance are everywhere apart from in the prices”. 9 Statement of the Problem We think that price adjustments are likely because... ▶ If the market erroneously underestimates the reality/gravity of climate change, and as corporate cashflows over time turn from ‘discounted expected’ to ‘realized’, and expectations will have to change. ▶ Revision in expectations that will then give rise to large price-adjustments. ▶ If, instead, the market is pricing in a ‘soft landing’ scenario: 1. this outcome should not be taken as an almost certain scenario (big uncertainty); 2. it would have very strong sectoral effects (which instead appear small); and. 3. it is extremely optimistic, since the 1.5 C target is in practice virtually unachievable, and that even 2 C is a ‘stretch’. 10 Do Prices Respond to Climate Shocks? ▶ The most direct way to estimate a climate beta is to carry out a regression of observed asset returns against a suitable climate index (after controlling for the other known factors). ▶ Unfortunately, there is no obvious observable proxy for climate risk. ▶ Different approaches have therefore been followed to create an index (a time series) representative of climate risk, eg, from textual analysis. ▶ The out-of-sample explanatory power of these early indices has been low: after controlling for established factors, the incremental R² statistics is of the order of a few percentage points. ▶ Using an advanced version of this approach, Maeso and O’Kane (2023) obtain statistically more significant result, but, then again, only for one special combination of the several indices they build. 11 Do Prices Respond to Climate Shocks? ▶ Given these problems, Chini and Rubin (2022) have tried to capture latent factors and time-varying loadings by introducing observable characteristics that instrument for the unobservable dynamic loadings. ▶ When they use this technique to explain the returns of corporate bonds, they find that a ‘[s]ystemic environmental factor does not help to explain bond returns on top of financial standard factors’. ▶ In the case of equities, only for the most obvious sectors, Oil and Utilities, the increase in the R² is statistically significant, and even in this case by very modest amounts (a few percentage points). 12 Do Prices Respond to Climate Shocks? ▶ A separate strand of research (see, eg, the work by Pastor and Staumbaugh (2022)) has looked at the construction of long-short portfolios, whose returns should be proportional to the latent climate factor. ▶ This approach has one significant advantage over the index route: perhaps there has been a readjustment of prices, but this has occurred as a gradual process of growing climate awareness, not directly linked to specific ‘climate news’. ▶ There is a problem, though: it is not obvious which securities should go in the long and short portfolios (indeed, the approach is somewhat circular). 13 Do Prices Respond to Climate Shocks? ▶ Whatever the sorting method, the results are far from clear, with the field evenly but unhelpfully split: ▶ half the researcher find that only the returns of green assets are affected by climate risk; ▶ the other half draw the same conclusion but for brown assets. ▶ As Chini and Rubin (2023) conclude, “[b]y choosing different measures [one obtains] different results: [the] sign of the ‘greenium’ [and hence of the climate beta] is not clear.” 14 Are Climate Outcomes Price-Relevant? ▶ We said that a possible explanation of why prices appear to respond so little to climate information could be either 1. because climate damages are expected to be small even if climate risk is left unmanaged; or 2. because the market expects that efficient mitigation actions (emission abatement, carbon removal, adaptation) will limit climate change or make its effects ‘innocuous’. ▶ The distinction matters: 1. If ‘climate change does not matter’, then no big readjustments of the economy will be required. 2. But if it is mitigation and adaptation that will mute the effect of climate change, this will require a major re-wiring of the whole economy, and sectoral effects should be strong. ▶ We therefore look at these two possibilities separately. 15 Does Unmanaged Climate Risk Matter for Asset Prices? ▶ The first possibility (that unmanaged climate risk will have little effect on cashflows) is difficult to justify. ▶ Under a business-as-usual scenario, the concentration of CO2 in the atmosphere would most likely continue to grow at its current rate, which, it should be remembered, is still almost exponential, as shown in Exhibit 3. ▶ Exhibit 4 shows the modest decrease in the exponential growth rate experienced since the 1960s. 16 Does Unmanaged Climate Risk Matter for Asset Prices? Figure 4: The natural logarithm of the CO2 annual emissions from 1900 and a linear fit. Figure 5: same quantity for the years 1960 to date and a quadratic fit. 17 Does Unmanaged Climate Risk Matter for Asset Prices? ▶ If emissions continue along the current business-as-usual trajectory, temperature increases around 3 C and possibly more by the end of the century are very likely¹. ▶ The associated economic damages are admittedly very imperfectly know. ▶ However, a number of serious studies project very severe consequences. ▶ Even if there is disagreement about the magnitude of the economic damages, the sheer magnitude of the uncertainty about what could happen should be reflected in prices. ¹ The human species has never experienced these temperatures, as we have to go back some three million years ago to find similar global temperatures 18 Will Climate Risk Be Successfully Mitigated? Could it be that the market correctly expects the effect of climate change to be successfully managed? ▶ This is very optimistic because 1. we are very uncertain also about temperature outcomes given CO2 concentrations – therefore a strong confidence in our ability to engineer a ‘soft climate landing’ is misplaced; 2. the policy changes required for the soft landing are unprecedented, both quantitatively and qualitatively; 3. these policy changes are difficult to reconcile with the possible development trajectories of those parts of the world (such as subSaharan Africa) that have not experienced sustained economic growth to date. ▶ Let’s consider these points in turn. 19 Will Climate Risk Be Successfully Mitigated? Could it be that the market correctly expects the effect of climate change to be successfully managed? ▶ The sharpness of the target of 1.5 to 2 C of warming by 2100 suggests that we can steer our emissions to achieve a desired temperature with tenth-of-degree precision. ▶ Indeed, this is the impression conveyed by graphs such as those shown in Exhibit 5. ▶ The reality is very different. ▶ One of the key inputs to the climate models used to link emissions to temperature is the Equilibrium Climate Sensitivity. ▶ Exhibit 7 shows a fit to the dispersion of estimates of this quantity found in the literature for this key variable. 20 Will Climate Risk Be Successfully Mitigated? Figure 6: Emission paths consistent with 1.5 C warming by 2100. Figure 7: Emission paths consistent with 2.0 C warming by 2100 21 Will Climate Risk Be Successfully Mitigated? Figure 8: Emission paths consistent with 1.5 C warming by 2100. 22 Will Climate Risk Be Successfully Mitigated? Figure 9: Historical and projected emission path consistent with 2 C warming by 2100. Figure 10: Temperature outcomes consistent with the same emission path for different climate models. 23 Will Climate Risk Be Successfully Mitigated? ▶ Clearly, the inversion of the historical emission trend required to stay, on average, below 2 C must be sudden and extremely steep. ▶ If not at a global level, has a similar rate of decline been observed at least for some countries? ▶ What were the policy choices of these fast abaters? ▶ Could, in short, the experience of these countries become a template for successful decarbonization? 24 Will Climate Risk Be Successfully Mitigated? ▶ One must distinguish carefully between 1. developed countries; 2. fast developing countries; 3. countries that still have to develop ▶ The development trajectory of the still-to-develop countries holds the key to future global warming. ▶ Part of the reason is that early stages of development rely heavily on sectors (steel, cement) that are very difficult to decarbonize. 25 Will Climate Risk Be Successfully Mitigated? Figure 11: Emissions (India). Figure 12: Emissions (China). 26 Will Climate Risk Be Successfully Mitigated? Figure 13: Emissions (US). Figure 14: Emissions (France). 27 Will Climate Risk Be Successfully Mitigated? Figure 15: Emissions (Nigeria) – cement ≊ 10%. Figure 16: Emissions (Kenya) – cement > 10%. 28 Will Climate Risk Be Successfully Mitigated? Summarizing our results so far: ▶ If we focus on cement-related emissions as a proxy for emissions that are difficult to curb via renewables, we distinguish three clear different patterns: 1. for strongly developing countries such as China and India, they are growing roughly at the same pace as total emissions; 2. for developed countries, they are in general falling faster than total emissions are; 3. for still-to-develop countries they are growing at a faster pace than their total emissions. ▶ See Exhibit 17. 29 Will Climate Risk Be Successfully Mitigated? Figure 17: The fraction of the cement-related emissions to total emissions against the GDP/person (x axis, average of the 2015-2020 data) for 20 countries. Best fit to the function frac = α × GDPβ Figure 18: Ratio cement-to-total CO2 emissions for several countries. 30 An Optimistic Estimate ▶ Let us be optimistic and assume that the rate of emission reduction similar to what has been achieved by the best-in-class. ▶ If replicated on a global scale, would the cuts in the emissions carried out by the most ‘aggressive’ countries be enough to meet the 2 C target? ▶ If everybody started cutting emissions tomorrow at the fastest sustained pace so far observed anywhere in the world, would the global abatement curve be as steep as the right part of the graph in Exhibit 8? 31 An Optimistic Estimate Figure 19: Per capita CO2 emissions (France). Figure 20: Share of energy consumption by source (France). 32 An Optimistic Estimate If we consider that 1. 2. 3. the fast pace of emission reduction experienced by the fastest abater (France) was due to a nuclear choice that currently few countries seem willing to embrace; that even if the French rate of emission reduction were somehow universally adopted, we would in all likelihood still fall short of the 2 C target; that many highly emitting countries are still increasing their carbon emissions, it seems very unlikely that the pace of abatement will be as high as required by a trajectory such as the one shown in Exhibit 8. 33 An Optimistic Estimate A soft-landing scenario therefore implicitly relies 1. on all countries adopting abatement policies faster than what has been observed for the fastest abaters to date – achieved thanks to a unique commitment to nuclear energy – and faster than the current pledges; 2. on technological breakthroughs occurring very soon in carbon sequestration and storage, in direct carbon removal, and in largescale non-fossil-fuel solutions for the production of cement, steel and nitrates; 3. on these breakthroughs being shared (presumably with accompanying subsidies) with developing economies. 4. This is not a central scenario. 34 A Bit of Theory ▶ To arrive at prices, cashflows must be discounted. What is the correct discount rate? ▶ Consider the simplest case (no uncertainty, time-separable CRRA utility functions) of the Ramsey equation, which derives the discount rate, r , as r=δ+γg where δ is the rate of impatience (the utility discount rate), γ is the inverse of the elasticity of intertemporal substitution, and g is the rate of consumption growth (Δ log c) – closely linked to the rate of growth of the economy. ▶ Ramsey’s equation assume certain cashflows – a very dubious assumption. 35 A Bit of Theory ▶ If we allow for uncertainty, we get where σ²(Δ log c) denotes the variance of consumption growth. ▶ If anything, the presence of additional uncertainty due to climate risk would increase the variance of consumption, and the precautionary-savings term would make the discount rate lower. 36 A Bit of Theory ▶ If there is such a large degree of uncertainty about the correct discount rate, are firm conclusions about its effects unwarranted? ▶ Weitzman shows that in the case of uncertainty about the correct discount rate, for distant cashflows one should use the lowest possible rate – the more distant the cashflow, the lower the rate of discounting. ▶ And, with a not-particularly low discounting rate of 2%, cashflows in 40 years’ time do not disappear – they are reduced by 55%. ▶ Therefore, even if climate damages were a very long way in the future, they would still produce a change in discount rate. ▶ Barring near-miraculous cancellations, this change in discounting should have affected today’s prices. 37 Conclusions ▶ A black-and-white description of the current global-warming predicament points to two polar scenarios: 1. if we control effectively climate change, the world economy will have to undergo a transformation that some macroeconomists have described as ‘precipitous’; 2. or we venture into uncharted climate waters, with temperatures fast approaching and perhaps exceeding levels (3 C) never experienced by the species Homo Sapiens. ▶ There are, of course, shades of grey, but not much room for maneuver: just one more decade of ‘muddling through’ would effectively close most realistic pathways to 2 C by 2100. ▶ Plus, there is much greater uncertainty about the physics of the problem than we usually acknowledge. ▶ Even the more benign scenarios hide, behind the facade of a smooth aggregate transition, profound macroeconomic shifts, which must have deep sectoral price reverberations. 38 Conclusions ▶ In either of the polar scenarios above, and in all the intermediate outcomes, transition and physical climate risk will have large aggregate and/or differential impacts on cashflows of firms and governments. ▶ If, as we have suggested, these have not been properly factored in current valuations, significant price adjustments can be expected. If these price adjustments will be gradual, this will create a long-term drag on portfolio returns. This would be the most benign form of repricing. ▶ There are precedents, however, of much more sudden price adjustments – look no further than the 2008-2009 subprime crisis... ▶ Volatility and loss of liquidity can also be expected, with potential macrostability implications. 39 Slow Response of Equity Markets...? Figure 21: The Nasdaq index 2006-2009. Figure 22: The Non-Investment OAS spread 2006-2009. Figure 23: Base correlation 2006-2009 40 Conclusions Can one guess the timing of the readjustment (of the ‘Minsky moment’)? ▶ Every real-world or financial crisis (COVID, Russia/Ukraine, disruption to energy supply, inflation shocks) temporarily pushes climate abatement off the attention radar, and delays the transition (desire for ‘energy security’ versus ‘acceleration renewables’). ▶ The more ‘crises’ we experience, the larger the final readjustment is likely to be. ▶ In the West and in the Global South, opposition to climate change is rising among ‘populists’, who are depicting climate-change concerns as ‘rich, white people’s worries’. 41 Conclusions Can one guess the timing of the readjustment (of the ‘Minsky moment’)? – ctd. ▶ The high level of public and corporate debt makes investment in abatement policies more difficult – also in this respect, every crisis (military support for Ukraine, COVID furlough schemes, fiscal help for the energy crisis) reduces the available resources for abatement. ▶ Government intervention is more needed for the second phase of decarbonization: removal, capture and storage. Fiscal room (UK ‘Truss episode’) and willingness to raise taxes (US) are limited. ▶ All of this can only delay the enactment of effective policies. ▶ Every policy delay makes the climate damages higher, and the potential final price readjustments more abrupt. 42 Conclusions What could trigger the repricing? ▶ Extremely difficult to tell. ▶ If sudden, the Minsky moment could be due to an exceptional weather event, perhaps localized in a major Western urban centre, with high media coverage. ▶ An unexpected and sweeping regulatory move could have a catalytic effect as well – the two could be linked. ▶ For the high-impact regulatory move to have ‘legitimacy’ and to be politically possible, it would probably have to come in the wake of some high-profile instance of physical damage, again probably in a Western country. 43 Q&A session 44 Thank you! About us: Marking the priority assigned by the School to sustainability issues and building on its research programmes exploring the relationships between climate change and finance, EDHEC-Risk Institute became EDHEC-Risk Climate Impact Institute (EDHEC-Risk Climate) in the Fall of 2022. EDHEC-Risk Climate’s mission is to help private and public decision-makers manage climate-related financial risks and make the best use of the financial tools available to transition to low-emission and climate-resilient economies. Our core ambition is to become a leading academic reference point for long-term investors, helping them to manage the asset-pricing implications of climate change. 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