- Financial markets process complex information every day. The impact of climate change is no exception.
- Academic research provides compelling evidence that prices in a variety of asset markets incorporate information about climate risk.
- These findings also suggest that firms have incentives to manage their climate risk exposure, as a higher exposure can result in a higher cost of capital
The economic effects of climate change may be substantial—and may unfold over decades. Climate change can, therefore, affect the future payoffs of a wide range of assets. Given this strong potential impact, a central question is whether markets do a good job of reflecting climate risk in asset prices. Since the effects of climate change are uncertain and potentially long-lasting, some worry that markets might struggle incorporating information about climate risk. Let’s not forget, however, that financial markets assess many other complex and uncertain events every day. Examples include the potential changes in consumer demand and business practices after the pandemic, the impact of current stimulus spending on future inflation, the evolution of international political and trade relations, and the impact of technological innovation.
Since the pioneering work of Fama et al. (1969), ample academic research has shown that financial markets are remarkably good at processing new information.1 Thanks to intense competition among many market participants globally, prices quickly reflect news about the economy, scientific advances, and geopolitical developments. What about climate risk? It appears to be no exception. As we document in a recent Dimensional paper, research shows that prices in a variety of asset markets incorporate information about climate risk.
PRICING OF PHYSICAL RISK
Physical risk refers to the direct effects of climate change; a coastal property exposed to increased flooding risk would be an example. Painter (2020) notes that municipal bonds offer an interesting setting to study exposure to physical risk, since, unlike corporations, municipalities cannot relocate to avoid the physical effects of climate change. His study, along with Goldsmith-Pinkham et al. (2020), finds that higher exposure to sea level rise is associated with higher municipal bond yields. Importantly, the relation is mostly driven by long-maturity bonds. These results suggest that investors do consider the long-term effects of climate change.
The real estate market offers another important source of evidence. Like municipalities, buildings are essentially impossible to relocate and exposed to physical risk. Bernstein et al. (2019) find that houses exposed to sea level rise sell at a 7% discount to properties with similar characteristics. Interestingly, most of the discount is driven by houses not at risk of being flooded for another 50 years. Even in decentralized, less-liquid markets such as real estate, there is evidence that prices reflect long-run climate risk.
The futures market also provides evidence that investors price the physical risks of climate change. Schlenker and Taylor (2019) look at climate futures traded on the Chicago Mercantile Exchange between 2002 and 2018. The key finding of the study is that warming trends predicted from climate models, inferred from futures prices, and measured from observed temperatures all coincide. The study thus shows that investors transacting in the climate futures market have expectations in line with the scientific consensus. The setting also allows the authors to confirm that these investors do not systematically underestimate or overestimate future temperatures.