Are capital markets pricing in climate change? This is a big and very topical issue. Evidence that global warming is occurring mounts by the day, and talking about it moves ever more into the mainstream.
No chief executive of a listed company ought to be surprised to be asked a question about the climate in a public forum. To look competent, she or he ought to have something to say on the subject. But the consensus is that capital markets are not paying enough attention to it. And there is plenty of evidence to support that view.
Twenty years after Margaret Thatcher addressed the UN General Assembly on the “irretrievable damage” threatened by climate change, capital markets financed a shale fracking boom that has doubled US oil production in the last 10 years.
Over the same decade, the volume of talk about green and sustainable finance has far more than doubled. But while the markets are starting to get their heads round the issue, their bodies are still walking the same old walk.
ExxonMobil’s share price may be 20% off its peak — but relative to earnings, the stock is valued more highly than at its 2014 crest.
The great and the good — led by Mark Carney, Bank of England governor, and Michael Bloomberg, the media entrepreneur — are on a campaign, known as the Task Force on Climate-related Financial Disclosures (TCFD), to persuade companies to start looking climate change squarely in the face. If corporate boards disclose their strategy towards the issue in their annual reports, investors might have some chance of knowing how to reallocate capital towards firms that are part of the solution.
Central banks are getting in on the act. Slowly but surely, their surveillance and stress tests are going to tease out the climate risks lurking in the balance sheets of banks and insurance companies.
But even the most sophisticated banks admit that they are barely off the starting line in calculating climate risks, whether from physical weather changes or the economic transition, which could render old technologies obsolete.
The general view, then, is that enormous work is needed to help markets properly understand and hence price these perils — and their corresponding opportunities. But there is a more frightening possibility: what if markets are pricing them already?
A study published this week by two London universities, Imperial College Business School and the School of Oriental and African Studies, finds evidence that developing countries that are vulnerable to climate change have higher government bond yields than states with comparable economic strength but less climate risk.
The research, based on bond yield data from 1997 to 2016, estimates the extra cost at 117bp, on average. This amounts to a total of $40bn of extra bond interest for the affected countries over the past 10 years — and another $22bn for their private sector issuers. And the study does not count the extra risk premium that would inevitably be factored into these countries’ domestic bond and loan markets, equity markets and so on.
The implications are alarming. If the research is confirmed to be accurate by further studies, it would mean that capital markets had begun to charge extra for lending to climate-vulnerable countries, a long time ago, and probably in a largely unconscious way.
If, as most observers believe, markets have still hardly begun to pay conscious attention to climate risk, then when they do, these vulnerable countries are going to be staring down the barrel of a steep increase in financing costs.
There are two further worrying conclusions to be drawn. If the markets have, unconsciously, perceived the climate change exposure of countries such as Ghana, Tanzania and Nepal and priced them in, then it also implies that the prices of oil stocks could be incorporating the market’s estimate of climate risks.
In other words, the market has thought about climate change — and decided the oil groups will not change their business models.
At a more profound level, the research on government debt points to a truth that is permanent, but rarely referred to. Clearly, sooner or later, markets will begin to price the risk of climate change. Good — markets’ understanding of risk and reward needs to be engaged in the fight against global warming.
But that is very far from being an adequate response. If institutional investors all realise climate change is happening and move their money to higher ground, it will do nothing to help Fiji, Vanuatu, Bangladesh or Chad.
Thinking that goes beyond risk and reward is needed. Markets must be refashioned around solutions — the investments that will actually prevent and ease the effects of drought and floods.
Ultimately this is in the self-interest of all investors: no securities will be worth much in an uninhabitable world. But individual interests, protecting their own portfolios, cannot achieve this. Only a collective endeavour can do it.
That means the public sector will have to take the lead. If it is done cleverly, the private sector can be engaged to put its shoulder to the wheel. Solutions may include creating insurance-like techniques for pooling catastrophe risk, or designing mechanisms to make flood defences — which currently produce no revenue — financeable.
It would help if private markets could begin to recognise, now, that they are going to be called on to go deeper in their thinking than risk and reward.