Aggressive decarbonisation key to preventing stock market write-offs

Net Zero Investor 23/07/2024

"Climate risk could have a significant impact on equities, with climate tipping points potentially wiping off half of global stock market valuations, researchers warn

Estimating the impact of climate risk on equity valuation is a subject of frequent scrutiny and understandably so. For investors and regulators – these techniques are the heart of their understanding of how systemic financial risk emerges from climate change.

New research from the EDHEC-Risk Climate Impact Institute finds gaps in valuation techniques that investors rely on. Adapting a new methodology, the research team led by the institute’s scientific director Riccardo Rebonato, reports that the impact of climate risk on equity valuations could be more significant than what previous estimates suggest.

Physical risk and asset valuation

Broadly speaking, climate change effects flow into asset valuations through two channels – physical risk and transition risk.

Rebonato and his team contend that transition risks tend to be the focus of most valuation methods. A consequence, they argue, of transition risks being “front-loaded”.

Even studies looking into physical risk tend to find that such risks are either not priced in or report that the consequent effect on valuations is small.

“Should the effect of physical risk on asset prices really be so negligible?”, the researchers ask.

Thus far, according to the research, physical risk has only affected valuations modestly. To Rebonato and his team, this suggests that the wider market holds one of two beliefs: first – that climate damages are overestimated or second, that decarbonisation will accelerate significantly in the future.

“Neither belief can be proven to be factually wrong, but both are very far from being close-to-certain”, the study warns.

The cost of not accelerating

Using methods that jointly estimate effects of both transition and physical risks, they find that the aggressiveness of abatement, is a key determinant of valuation shocks.

“If we abate little, physical damages are, naturally, much larger, and dominate the transition costs. So, ‘when it really matters’, physical damages are more important”, the research finds.

Rebonato’s team also finds that the impact of climate risk on equity valuation depends on the pace of future emissions reduction. In other words if decarbonisation does not accelerate in the future, equity valuation shocks could be larger.

“Over 40% of global equity value is at risk if decarbonisation efforts do not accelerate, with losses exceeding 50% when climate tipping points are factored in”, the research finds.

Factoring in uncertainty

The team’s approach to modelling climate risk is a probabilistic one – where economic changes attributed to climate change are not assumed to carry a given degree of certainty.

One of the key takeaways for investors, the paper concludes, is that uncertainty surrounds all climate-risk estimates and any subsequent asset valuations. Most prevalent approaches to modelling climate risk have one caveat according to Rebonato’s team:

“Whatever one’s view about the returns to be expected from an asset class, our uncertainty about this view radically changes the optimal allocation”.

In other words, there’s a lot riding on how ‘climate aware’ valuation techniques are: “These results–obtained with mild assumptions–underline the importance of uncertainty and state dependent discounting for climate-aware equity valuation”, Rebonato concludes" 

Copyright Net Zero Investor

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Aggressive decarbonisation key to preventing stock market write-offs