- 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 Please see the end of this document for important disclosures.
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.
PRICING OF TRANSITIONAL RISK
Transitional risk arises because of the uncertainty surrounding the transition to a low-carbon economy. There is uncertainty, for instance, around both the timing and scope of new environmental regulations. As a result, firms whose business models depend on high fossil fuel use are likely to have high exposure to transitional risk.
Griffin et al. (2015) find that the stock prices of the 63 largest US oil and gas energy firms fell by 1.5% to 2% after the publication of a landmark paper in Nature (Meinshausen et al., 2009). The latter paper argues that most fossil fuel reserves would need to remain untouched if warming is to be kept under 2°C by 2050; for comparison, the objective under the Paris Agreement is to limit all future warming at 2°C, an even more stringent objective. Therefore, most reserves would become worthless under aggressive mitigation policies. Consistent with the idea that asset prices reflect climate risk, markets reacted in the three days following the publication of the article in 2009, although the article was only publicized by the press a few years later.
Looking at other examples of transitional risk, Chava (2014) finds that firms with negative environmental externalities face a higher cost of capital, while Delis et al. (2019) contend that fossil fuel firms incur higher interest rates on syndicated bank loans. In both cases, the mechanism in question has to do not with the direct effect of global warming on firm performance, but rather with potential regulatory or reputational risk. Ilhan et al. (2021) find that equity option prices reflect climate policy uncertainty and that downside risk is costlier to insure for more carbon-intensive firms. Seltzer et al. (2020) look at regulatory risk specifically and find that the bonds of firms with a poor environmental record were more likely to experience rating downgrades and yield increases after the passage of the Paris Agreement. All these studies suggest that asset prices reflect the potential impact of climate policy or changing consumer tastes.
Overall, a growing body of evidence shows that prices across many different markets (stocks, bonds, climate futures, equity options, and real estate) incorporate information about climate risk. This pattern is consistent with the behavior we would expect in competitive markets: buyers and sellers have incentives to use all the information at their disposal to value assets, and the literature suggests that information about climate change is no exception.
These results are also encouraging news for everyone concerned about climate change. Financial markets seem to pay attention to climate risk despite its complexity. Moreover, competitive market forces provide firms with incentives to better manage their exposure to climate risk to reduce their cost of capital.