Pricing in climate change risk

In the month since the International Panel on Climate Change (IPCC) 6^th Assessment Report (Working Group 1) landed in inboxes, financial markets don’t seem to have taken any notice of its worrying conclusions. If, as the science warns, the real-life consequences are likely to be more devastating and intractable than the Covid-19 crisis (which saw a sharp initial sell-off), why do equity markets seem invulnerable to the climate emergency?

At Tribe, we see a significant economic risk from rising temperatures and consequent rising sea levels and extreme weather patterns, yet we don’t envisage a sharp climate risk related market correction in the near term. We believe the change in markets, based on potential climate risks, is likely to be gradual, as policy measures are more widely adopted by governments and more widely acknowledged by market participants. Ahead of COP26, we believe now is the time for wealth and asset managers to position themselves for tighter regulatory and policy changes as a result of more widescale commitments and reforms pledged by countries around the world.

In the first report from Working Group 1, the IPCC brought forward the probability of global temperatures exceeding a 1.5 degree increase from the 2040s to

a 50% probability of this happening in the next 10 years 1

International Panel on Climate Change (IPCC) 6^th Assessment Report (Working Group 1)

For climate scientists, this represents an extremely serious acceleration of risk. Yet for financial, and especially stock analysts, the long timeframe coupled with the uncertain probability, hasn’t been enough to turn more negative on valuations, as estimates for companies’ earnings in the short term (which drives most valuation approaches) are not being materially affected – yet. In short, given that there has been no reduction in consensus earnings forecasts, there is no tangible reason for a re-pricing. Based on this, it’s difficult to think of any single event which could cause a market wide re-pricing as a result of increased perception of climate risk.

This is in stark contrast to February 2020, when the market reacted quickly to the economic consequence of the severity of the Covid-19 pandemic and the subsequent lockdowns in many markets around the world. In the four weeks following on from Italy’s lockdown in Lombardy on 20^th February 2020, the MSCI Global Equity Index fell by a third. 2 Covid is a human health crisis, that required countries to lockdown in an attempt to control it. The economic impacts of those lockdowns were instant. Welfare systems were overwhelmed in a short period of time. People lost their lives, many businesses closed and global trade was disrupted.

The climate crisis is very different in nature, more gradual, seemingly fragmented and takes many different forms. Unlike Covid, this multiplicity of how it presents means the symptoms of the climate crisis are everywhere (from people displacement, crop failure, flooding, desertification, fire, increasing levels of disease, to name just some). They are also heavily interconnected. The question, therefore, isn’t when will the markets respond, they will, but how do they respond to such an extensive and unpredictable challenge?

We believe the primary driver will come from an improved Policy and Regulation framework to nudge the market into better behaviour. Changes in accounting practice will be important in driving more accurate disclosure, which could lead to changes in valuation approaches. We’ve recently seen the scale of the problem, with widespread lapses in climate reporting uncovered. 3 The work of the Impact Weighted Accounts Initiative at Harvard, developments with the International Financial Reporting Standards Foundation sustainability related reporting initiative, work by the Sustainability Standards Board (ISSB) to set IFRS sustainability standards and the Taskforce on Climate Related Financial Disclosure (TCFD) are just some developments which signal a new age in impact disclosure. And they will change fundamental investment analysis. Upgrades to the system itself, like those the Better Business Act (BBA) are calling for, will help drive companies to be rooted in sustainability and purpose via changes to company law. More accurate and forecast data relating to the financial impacts of the climate crisis, like Climate Value at Risk (CVaR), will help the markets to respond ahead of time, and to better understand the scale of the response that’s needed.

The establishment of a global carbon tax, coupled with an increase in the reach and scale of emissions trading schemes (ETSs) will also help repurpose the system and ensure that companies begin to internalise the cost of their negative climate externalities. Within the latter, for example, the EU ETS is now functioning more effectively. According to the EU, installations covered by the ETS reduced emissions by about 35% between 2005 and 2019. 4 This success has led to an increasing ambition, and in July, the EU increased its 2030 carbon reduction target from 40% lower than 1990 levels, to 55% lower and is also expanding the scope of the scheme to include new sectors like maritime. 5 In addition, wider corporate adoption of Science Based Targets (SBT) will also work harder to establish businesses true exposure to carbon emissions by requiring disclosure on Scope 1, 2 and 3 of their businesses, with the latter including the business operations of their supply chain.

These steps together can help unlock fundamental changes into how companies are assessed for value and should also catalyse a longer-term valuation approach from both management teams and asset and wealth managers.

This aligns to our investment approach, where our portfolios are positioned to channel capital into those businesses supporting a socially responsible and economically sustainable future. Our “twin-lens” methodology to the assessment of value looks at both the financial and sustainability merits of the company operationally, and in terms of product and service. We believe this approach can also uncover companies that are creating a competitive advantage by future proofing their businesses against the risks stemming from changes in both government and society.

We see these changes coming and believe they will compel markets to begin to price in climate risk more accurately. Wealth and asset managers should respond now by building portfolios which exhibit greater earnings resilience as global regulations and investor awareness continue to grow.