Climate-related asset risks are getting physical
In a recent paper, How Does Climate Risk Affect Global Equity Valuations? A Novel Approach, the EDHEC-Risk Climate Impact Institute notes that up until now, transition risk has received more attention than physical risk when assessing how climate risk can affect asset valuations.
Investors often assume that the regulatory climate risks to a business are likely to be front-loaded and, therefore, more relevant to valuation than the more ‘distant’ physical damages that are expected to fade in significance by virtue of being ‘discounted away’.
However, the paper says “physical and transition costs are two sides of the same valuation coin: the greater the transition effort, the smaller the expected physical damages, and vice versa”.
The Institute argues current equity valuations seem to reflect investor belief that either strong and effective abatement action will be undertaken and climate change brought under control; or that climate change, even if poorly abated, will have a negligible effect on economic output and consumption.
“Since neither assumption should be considered a very likely scenario, we have argued that there is ample potential for equity revaluation,” it says.
This downward revaluation could range from a few percentage points to as much as 50 per cent, depending on factors such as the strength (or otherwise) of abatement policies and the nearness of tipping points.
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