The (significantly) underestimated financial costs of climate change
In this article, Riccardo Rebonato, EDHEC Professor and EDHEC Climate Institute (ECI) Research Director and Senior Advisor, looks back on an innovative paper (1), co authored with Dherminder Kainth and Lionel Melin (ECI), in which they assess how the value of global equities can be significantly affected by both physical climate damage and transition costs.
Losses in the value of global stocks could top 40% if no action is taken to bring climate change under control. That’s the striking finding of a paper called “How Does Climate Risk Affect Global Equity Valuations ? A Novel Approach”, my co-authors and I have published (1) as part of the EDHEC Climate Institute.
In 2023, the World Economic Forum had estimated the cost of climate change to be
between 1.7 trillion dollars and 3.1 trillion dollars per year by 2050 (2). But what about its impact on the world stock market value? And how could we evaluate it?
In our paper (1), we adapt established valuation techniques in an innovative way to
assess how the value of global equities can be affected by both physical climate damage
and transition costs.
The topic is not only important for investors, but also for prudential regulators, who need to understand how climate-sensitive assets may deteriorate in value and, in doing so, potentially endanger the liquidity and solvency of the institutions and threaten financial stability.
The unexpected impact of climate change
So, what would be the impact of climate change on asset prices? To answer this (very broad) question, the EDHEC Climate Institute has combined equity valuation techniques with an upgraded version of a popular Climate Integrated Assessment Model. The objective was to estimate the effect of physical climate damages and transition costs on the value of global equity stock.
The study found that the impact of physical risk on global equity valuation can be substantial. This is particularly true in a world with ‘near’ climate tipping points (3), which are critical thresholds that can lead to sharp increases in temperature if exceeded. However, we do not need nearby tipping points to have large equity losses.
The difference in equity valuation with respect to a world without climate damages mainly depends on 3 key factors:
1. On the aggressiveness of the emission abatement policy (the slower the abatement, the
greater the downward repricing).
2. On the presence or otherwise of nearby tipping points. As a reminder, a tipping point is a critical threshold that could lead to large and often irreversible changes in the climate system.
3. On the extent to which central banks are able and willing to lower rates in states of
economic distress.
This assessment is based on a fully probabilistic approach, which puts economic and climate uncertainty on center stage, and taking into account both transition and physical risks, meaning the direct damages arising from unabated climate change.
The result is thought-provoking, even in case of conservative modelling choices. The difference in equity valuations between a no-climate-damage world and a world with climate damages can range from less than 10% if prompt action is taken, rising to more than 40% in a close-to-no-action case. In the presence of climate tipping points, this range widens from less than 10% for strong abatement to more than 50% in the case of very low emission abatement.
It is interesting to note that, for all parameter choices, solid abatement policies strongly limit the impact of climate change on equity valuation.
An innovative approach
More and more companies and financial institutions are performing forward-looking assessments of their exposure to the potential impacts of climate change. For example, compliance with Task Force on Climate Related Financial Disclosures (TCFD) (4) recommendations requires disclosure of impacts in a Paris Agreement aligned (high-abatement) scenario and a business-as-usual (high emissions) scenario.
Analytics providers targeting investors offer tools to translate the climate-related
developments characterizing a scenario into asset-level metrics, such as the potential
impact on asset value. Typically, these tools return a single estimate for the metric, based
on the realization of the selected scenario.
However, this approach does not take into account the considerable uncertainty around climate change and its impact (5). Some investors have been criticized for reporting analyses based on these tools, which suggested their portfolios would only be marginally impacted, even in high-temperature scenarios that pose existential challenges to our societies.
It is time to change scenario analysis and climate-aware valuation tools. To that end, this study has adopted a top-down approach, incorporating state-dependent discounting (a feature that is often neglected in valuation) and integrating analysis of transition costs and physical damages. That way, we can understand how economic activity levels, influenced by climate impacts, affect interest rates.
What can we do?
As we have seen, solid policies to tackle climate change, consistent with the 2°C Paris Agreement target, could limit downward equity revaluation to 5-to-10%. On the other hand, the correction to global equity valuation could be as large as 40% if no urgent action is taken, even in the absence of irreversible changes. It is worth noting that tipping points exacerbate equity valuation shocks, but are not required for substantial equity losses to happen.
Climate change affects the environment in major and diverse ways. It is also a major source of financial risk. By enriching climate scenarios, we make them more practical and informative for those directing investments in climate-related projects and technologies. This is an essential lever in an effective management of climate change.
References
(1) How Does Climate Risk Affect Global Equity Valuations? A Novel Approach (2024) Riccardo Rebonato, Dherminder Kainth, Lionel Melin. EDHEC Climate Institute - https://climateinstitute.edhec.edu/publications/how-does-climate-risk-affect-global-equity-valuations-novel-approach
(2) Climate change is costing the world $16 million per hour (2023) World Economic Forum - https://www.weforum.org/stories/2023/10/climate-loss-and-damage-cost-16-million-per-hour/
(3) A tipping point is a crucial limit beyond which significant and potentially irreversible changes can occur in the climate system - https://en.wikipedia.org/wiki/Tipping_points_in_the_climate_system
(4) Task Force on Climate-related Financial Disclosures - https://www.fsb-tcfd.org/
(5) The problems with climate scenarios, and how to fix them (2024) Riccardo Rebonato. The Conversation / EDHEC Vox - https://theconversation.com/the-problems-with-climate-scenarios-and-how-to-fix-them-230141
(6) The Paris Agreement, United Nations Climate Change - https://unfccc.int/process-and-meetings/the-paris-agreement
