Asset-Pricing and Risk-Management Implications of Climate Change

Integrating climate risk in asset pricing and risk management models

If decisive action to curb climate change is taken, the financing of the abatement initiatives will require the coordinated deployment of private-sector initiatives, extensive government subsidies, targeted ‘sin’ taxes, and government funding of those strategic initiatives (such as nuclear fusion) that are too long-term and uncertain for the market mechanism to be effective. How these initiatives will be funded will have a major effect on classic macrofinancial drivers of asset returns, such as the level of national and corporate debt, the level of taxation, the degree of employment, the pricing power of labour, etc.

So, in addition to a specific ‘carbon risk factor’, how decisively climate change abatement initiatives are undertaken will affect asset pricing i) by adding new factor(s); ii) by altering the ‘betas’ of various assets to the traditional macrofinancial factors; iii) by changing the volatility of these factors; and iv) by changing the correlations between them.

Constructing robust and attractive climate change-aware investment portfolios will therefore require taking into account new factors, new interactions between factors, and the uncertainty (technological and political) surrounding the decisiveness of the commitment to abate climate change. 

EDHEC-Risk Institute (ERI) is uniquely positioned to take the lead in this research programme, because its areas of existing expertise are uniquely relevant to the task at hand.

Macro foundations of climate risk impact on asset prices

Linking climate outcomes to the macrofinancial drivers of asset returns as outlined above requires the application and extension of state-of-the-art Integrated Assessment Models (IAMs) such as DICE. These approaches are used as an attempt to establish a synthesis between climate change science and a macro description of the economy. ERI is actively and innovatively engaged in this research strand, and is devoting research efforts towards connecting the two existing strands (climate science and macroeconomics) with their asset pricing implications.

The presence within ERI of faculty members with past academic experience in the hard sciences is a unique asset in the adaptation of the existing IAMs to the task at hand. It also has an established track record in the construction of robust portfolios and efficient indices. 

In addition, there is great uncertainty over which abatement path will be followed, and so a satisfactory analysis must be rooted in a probabilistic approach. Thanks to its research on decision-making tools such as Bayesian nets, ERI has the ability to produce mathematically rigorous and intuitively appealing analyses of the different possible abatement outcomes. This can be used not only for portfolio construction, but also for rigorous scenario analysis and stress testing.