Climate risk is not being priced into assets
Financial institutions can help accelerate the decarbonization process necessary to halt climatic collapse but it requires that they have a better understanding of the risks posed by global warming.
In a keynote fireside conversation during Bloomberg’s Risk Regulation Week series of webinars, Kepos Capital founder Robert Litterman said climate change risks were “undeniable” but that the world is not prepared for them. Homes and infrastructure are built not for future risks but for those we can see now, and that’s not sustainable, said Litterman who is also chair of the Risk Committee.
Climate risk is investment risk
Risk management has some very simple lessons that apply to climate risk management, from considering worst case scenarios and non-linear responses, to being prepared in time.
While climate risks are somewhat reflected in certain industries, they’re not fully priced into companies or their assets. The good news is that companies are more aware of what needs to be done.
Litterman told the “Quantifying Climate Risk and Looking Forward” session that ignoring climate risks will put a financial burden on the economy. For instance, insurance rates will rise as underwriters factor in the rising probability of increasingly violent weather. And the costs of borrowing for municipalities will climb as rating agencies price in the possibility that climate change will undermine issuing authorities’ ability to raise tax dollars, increasing the chances they will default on their bonds.
Climate risks are not fully priced into companies or their assets, the former Goldman Sachs risk expert and one-time chair of the Commodity Futures Trading Commission’s Climate-Related Risk Sub-committee said. They are reflected in some industries, such as the automobile sector, where valuations of electric vehicle makers like Tesla are much higher than those of gas-engine car manufacturers.
Wake-up call
Elsewhere, though, the risks remain unaddressed. For instance, cleantech startups that are looking for solutions to address the damage of climate change don’t have valuations that reflect their potential.
The good news is that companies are more aware of what needs to be done. Litterman described as “a wake-up call” recent investor action against companies with poor environment, social and governance (ESG) records and those that don’t align with net-zero goals.
The best way to motivate capital is to offer incentives that discourage environmentally damaging activities, and putting a price on carbon would be the most effective mechanism he argued. When carbon is fully priced in, capital expenditure decisions would be made with consideration to how much those costs will affect companies’ ability to make a profit from their investments.
Carbon taxes already work in some places, for instance California and the Regional Greenhouse Gas Initiative on the east coast of the U.S., Litterman said. But the total cost of carbon in the U.S. is around the mid-teens dollars per ton, while in Europe it’s in the mid-$80s, closer to the $100 it should be. The absence of carbon pricing provides an implicit subsidy to the fossil fuel industry, he said, citing an opinion of the International Monetary Fund. The bottom line is that the polluter must pay, Litterman argued.
Global harmonization of carbon pricing would accelerate the net-zero transition and there are encouraging signs it will happen. Large economies such as China and India are eager to decarbonize, and in unison with Europe and the U.S. could lead a global transformation, he said.
How we can help
Today, effective and efficient ESG risk management and reporting practices can already be enabled through advanced tools that can ingest sustainability data from multiple sources, integrate it with a firm’s own ESG scores and other proprietary data, and perform advanced analytics to facilitate decision-making. To learn more about Bloomberg’s Sustainable Finance Solutions, please visit our website.