Equity investors face complex task of pricing climate risk

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Equity investors face complex task of pricing climate risk

Equity investors are facing the rising challenge of determining the price of the physical risk related to climate change in order to protect portfolios from the impacts on global financial stability and asset prices. The International Monetary Fund (IMF) published a report warning that the climate risk and its associated impact on assets related to climate change aren’t being reflected in equity prices, meaning any changes in investor perception of this risk could result in a decrease in asset values, creating a knock-on effect for investor portfolios and financial organisations.

The IMF stated that along with implementing measures to manage and adapt to climate change, improved analysis and information regarding climate disasters is necessary to manage the pricing of climate change associated with physical risks. The IMF has admitted that this will be a difficult task for equity investors. In response to the paper, David Kneale, the head of UK equities at Mirabaud Asset Management said that the investment market had not started to consider the challenge of identifying, assessing and pricing the physical risk. Kneale believes that further focus on accurate climate modelling of today’s environmental impacts and a thorough analysis of the timing of impacts would be necessary to improve the situation.

 

Assessing ESG Performance

The turbulent market experienced this year as a result of Covid-19 has led to many ‘ESG’ stocks outperforming other areas. According to the MSCI World ESG Leaders index, the top ESG performers have increased by 2% this year-to-date compared to the average MSCI Global return of 1.2%.

Kneale believes this performance change reflects businesses that are well positioned for traditional risk i.e. companies focused on reducing or replacing high emission activities or have clear strategic processes in place for their emissions. Kneale points out that there are very few businesses that have shown a clear plan of action to address the physical risks they may face in the long term. Kneale hopes that the investment market will become more focused on analysing long-term physical risks.

Rick Stathers, climate change specialist at Aviva Investors believes the difficulty with pricing the physical climate risks lies with the extended time frame for these risks to develop into a reality, resulting in a market not pricing it in the actual moment. Stathers points to some schemes that are focusing on the implications of exceeding the increase of 1.5 C and the inherent risk this would have on people and their business model, introducing pricing in the temperature alignment of investments. Stathers highlight that heating is a major challenge and will likely result in an increase in severe climate-related events that have short-term impacts on business cash flow. As a result, investors may focus their attention on the short term impact of physical events.

Ed Gouldstone, the COO for asset management group Linedata believes the report could rethink our global approach and how governments respond and intend to mitigate environmental and climate risks. Gouldstone believes the growth in ESG is an important change, stating that businesses unwilling or unable to meet high ESG standards will likely have less access to financing and other support measures. As a result, these businesses will be less likely to survive another crisis in the future. 

Investors moving towards ESG stocks not only represents a way of profiting from this growth but also a way to protect portfolios against future environmental events. Gouldstone believes these portfolios are the ones that will likely outperform others in times of crisis, enabling the businesses to focus their attention on lowering the frequency and impact of these shocks.

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