How climate change is key benchmark for financial markets to consider when pricing, investing in shares

How climate change is key benchmark for financial markets to consider when pricing, investing in shares

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In 2017, then-President Donald Trump withdrew the country from the landmark Paris Agreement; President Biden reversed this on his first day in office, enabling the US to rejoin earlier this year.

In April this year, Biden also set new greenhouse gas reduction targets, pledging to reduce emissions by 50 percent to 52 percent from 2005 levels by 2030.

Biden’s executive order on climate and financial risk directs federal agencies to report in coming months how climate will change their work and what they plan to do about it. Federal employees may have options to invest their pension funds in green businesses.

Vendors who sell goods and services to the federal government could be required to disclose emissions; the Securities and Exchange Commission may require companies listed on the stock exchanges to do the same.

More visibility into emissions data would allow financial markets to take climate risks into account in terms of pricing and investment. That, experts say, might reduce the chance of a financial crisis akin to the one that crashed the economy in 2008.

Reporting carbon emissions is crucial, says Bolton, to push policy in the right direction – and to stabilise economies as new environmental policies are put in place.

“The broad reason why you want disclosure – and disclosure that gets audited – is that you get more accurate, granular information about where emissions are, who has to make the most adjustments, and who is at the most risk in the transition,” he says.

With greater access to emissions and other climate data, the thinking goes, companies and investors can make more rational decisions for the future – accurately pricing their assets, goods and services with climate financial risks in mind, making the transition process more “orderly” and avoiding shocks in situations like Rothstein’s oil company write-off example.

“You don’t want to invest in crops that are not heat-resistant, or in buildings that are not flood-resistant. You may be building in the wrong parts of the world. You might be too close to the coast, rather than five yards up the hill,” says van der Ploeg. “Now is the time to make the decision about the changes that we know will be inevitable. It’s not whether, it’s when.”

The sooner the process gets going, experts say, the better. “The longer companies wait to close down their carbon-intensive assets, the more risk will be put in the system, and the more individual investors will be exposed,” says Irene Monasterolo, a climate economist at the Vienna University of Economics and Business and author of a 2020 review of climate change and finance research in the Annual Review of Resource Economics.

Better disclosures and procedures around climate risk may also fuel innovation and mitigation, says economist Andrew Lo, of the Sloan School of Management at MIT.

“Financial markets play a central role, not just in dealing with climate change, but in dealing with all big challenges. No matter what the challenge is, no matter how we deal with it, there’s a common denominator. You need money. And when you need money, you need finance.”

Efficient financial markets, fuelled by good information, could steer resources to technologies and companies that can speed the low-carbon transition. Markets can also function as a “sort of crystal ball,” Lo sys. “If there is a problem that is looming, you’ll see it first in the stock market. It is the canary in the coal mine.” Investors may demand a premium – a lower stock price – to purchase shares in firms with big exposure to climate risk.

In advance of the United Nations global climate meeting to be held in Glasgow this fall, young protesters marched through the city calling for rapid action on emission reduction goals as part of an international youth movement. The UN summit will have many challenges to address, not least how to prepare for the financial implications of climate change.

Monasterolo works to develop “climate stress test” models that incorporate climate change and policies into financial risk assessments that can point the way ahead for financial authorities and investors managing climate-related financial risk.

“Many existing climate economic models do not account for the role of finance and its complexity in mitigation trajectories,” she says. “Neglecting investors’ expectations toward climate policies and risks can give a false sense of security about the possibility of making the transition, and what is needed in terms of policies to achieve the Paris Agreement.”

When investors start to assess climate risks in their portfolios, she adds, companies feel the pressure to make changes.

In May, Monasterolo and co-authors published a study in Science that attempted to tease out “the interdependence between investors’ perception of future climate risk … and the allocation of investments in the economy.”

Recent research by Bolton suggests that investors are already taking carbon emissions into account when they price stocks, finding that companies with more emissions garnered lower prices and thus higher returns. That’s a sign that the market may already be exerting influence on companies and climate outcomes.

But much work remains to be done. Bolton says that Biden’s executive order on climate-related financial risk is not enough to bring about all the needed changes. Congress may have to act to bring about a more ambitious climate policy that severely limits or taxes carbon emissions.

“Executive orders are a step in the right direction, but there’s only so much you can do with an executive order,” he says. “It can help set the agenda for regulatory agencies. You can prod them, but you can’t force them.”

The rest of the world hasn’t really figured out disclosures either, Bolton adds; he notes that financial disclosures are expected to be a major topic of conversation at the upcoming United Nations Climate Change Conference in Glasgow this fall, where countries will assemble to try to advance the goals of the Paris Agreement.

Van der Ploeg says there’s “momentum” heading into the meeting, but he doubts the discussions will dwell on the painstaking planning and financing it will take to make things happen. “The question is,” he says, “how do you translate it into real policies?”

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