3 questions to Riccardo Rebonato on the Climate Risk Premium

Riccardo Rebonato, EDHEC Professor and EDHEC-Risk Climate Impact Institute Scientific Director, will present his webinar “Where is the Climate Risk Premium?” on 29 June 29. More than 900 people have registered so far, and here he answers a few questions on what attendees can expect to learn about at the event. 

What Is a Risk Premium, and Why Is It Important?

The return investors can expect to make from a financial asset depends both on the (discounted) expected cashflows that the asset will generate, and on the compensation for the riskiness of these assets.

The important thing to understand is that this risk must be considered in the context not of the asset in isolation, but of the whole ‘market’ portfolio. So, a financial asset that pays well when the market suffers overall risk, and therefore acts as a hedge. US Treasuries and German Bunds in the run-up to the COVID crisis are examples of assets that were perceived to provide a hedge to equity risk, and that therefore commended a negative risk premium. In these cases, one can think of the risk premium as the ‘insurance premium’ an investor would be willing to pay. 

So, the key points are:

1. the risk premium can make up a substantial part of the expected return of an asset; 
2. it can be positive or negative.

What Is the Climate Risk Premium, then?

These days investors speak about ‘brown’ assets (i.e fossil-fuel-intensive assets) and ‘green’ assets (i.e low carbon-intensive assets) all the time; what they generally mean by these terms are assets that will perform badly in the event of high climate damage, and vice versa.

The important thing an investor would like to know is whether they will be compensated for bearing climate risk or whether climate-exposed assets will carry a negative premium, much like Treasuries in the post-Greenspan era. At the moment, we know very little about the magnitude or even the sign of the risk premium associated with green and brown assets.

Ultimately, it all boils down to estimating whether, say, the shares of oil companies will perform well when the market as a whole posts strong returns, or vice versa. For those firms whose payoffs are correlated with climate damage, the sign and magnitude of the risk premium depends on whether the climate damage occurs when the economy is performing well or poorly. We still know very little about this.

Why Use a Theoretical Approach to Estimate the Climate Risk Premium?

Estimates of risk premia are usually carried out empirically, by employing sophisticated econometric techniques that have been developed over decades. However, these techniques are very data hungry – many decades of relevant data are needed to obtain robust empirical estimates.

In the case of climate change, we just do not have this luxury, because investors have only been paying attention to climate risk for the past 10-15 years or so (which is “just yesterday” in risk-premium-estimate studies). Indeed, those researchers who have tried to deploy the traditional tools to estimate empirically a climate risk premium have found results “all over the place”: contradictory, weak, and counterintuitive.

This is why, as we patiently wait to climate-relevant financial data to accumulate and for the empirical techniques to become usable, there is a pressing need for a first-principle investigation of what the climate risk premium should be (how large, of what sign, with what ‘term structure’). By a ‘first-principle investigation’, I mean one that uses the most solid and state-of-the-art techniques in financial macroeconomics to provide robust and useable answers to this pressing investment conundrum.

The EDHEC-Risk Climate Impact Institute has been set up to answer this type of questions. On 29 of June, I will discuss what the latest modelling tools can tell us about the climate risk premium, and what this means for investment professionals.  

This interview has been originally published on the EDHEC Vox platform.

You mayread Professor Rebonato’s contributions to the recent EDHEC Research Insights Supplement to Investment & Pensions Europe and Pensions & Investments and the inaugural EDHEC-Risk Climate Impact Newsletter.

Also, in a recent op-ed in the Financial Times "We need new tools to model climate risks", Profesor Rebonato called for an extension of the climate scenario framework.