“Death by a thousand cuts” - why climate risk isn’t priced in

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Net Zero Investor 03/05/2024

Net Zero Investor

"Riccardo Rebonato, professor at EDHEC Business School doesn't believe climate change will trigger a Minsky moment, he explains why investors should still be wary of current valuations

Riccardo Rebonato is professor of Finance at EDHEC Business School and EDHEC-Risk Institute and scientific director of the EDHEC Risk Climate Impact Institute. 

The EDHEC Climate Impact Institute launched in 2022 as a successor of the Business School's previous Risk Institute, indicating the importance the School has assigned to climate change as a material risk factor to the global economy. 

Much of the Institute's research output is now focused on assigning probabilities to different climate scenarios, a step which is crucial to investment decision makers, as Rebonato argues. 

Investors who wish to model for climate change already have different scenarios at hand, what is different about the Climate Scenario Analysis EDHEC is providing?

The quality of the IPCC sponsored SSP RCP scenarios is very high, they have been created by top academics, there is no question about it. The problem is that they were not created with investors in mind. They fall short of providing the information investors need. By design, they have been created without any probabilities attached to them at all.

If you are a regulator or a policy maker, you may want to apply a precautionary principle. However, if you are an investor, there is no right way to be wrong. If you are too conservative or too aggressive, the underperformance of your portfolio can be just as severe. What is missing are the probabilities for certain scenarios.

Investment regulators tend to look at the most extreme scenarios. In reality, this also means that they are looking at the least likely outcomes.

What we are trying to do is to associate an approximate probability to these different scenarios so that investors can make a call about what is an unlikely scenario and what is a clear and present danger. When it comes to making investment decisions, this is fundamentally important and it’s missing.

We are trying to talk as much as possible in the language of the SSP [Shared Socioeconomic Pathways]. For better or worse, they have become the benchmark so there is no point swimming against the tide but let’s try to complement the information that is available.

Another issue with the SSP scenarios is that they don’t give any idea on variability and the variability is huge.

Modern finance is centred around risk and reward. Risk means uncertainty in outcomes, by collapsing these variants to a single outcome, you don’t give investors the ability to judge the trade-offs they need to make between risk and return. We are providing scenarios which are as similar as possible to the SSP scenarios equipped with probabilities of occurrence and an idea of the uncertainty around these scenarios.

At the end of the day, all these complicated stories come down to assumptions about economic development, demographics and technological development so why not just model them? (...)

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“Death by a thousand cuts” - why climate risk isn’t priced in