Impact of Climate Change on Asset Prices and Investment Management

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THE IMPACT OF FINANCE ON CLIMATE

The main research goals of this research strand are to:

  1. 1) Identify the possible impacts of climate change (due to physical and transition risk) on economic output
  2. 2) Identify the possible impacts of climate change (due to physical and transition risk) on different asset classes and industrial sectors
  3. 3) Construct optimal climate-risk-aware portfolios and strategies
  4. 4) Estimate the ‘climate beta
  5. 5) Estimate the climate risk premium
  6. 6) Assess the channels through which climate risk (physical and transition) can affect the financial system and, as a consequence, the real economy
  7. 7) Develop internally coherent and financially grounded climate stress tests and scenario analyses 

 

What This Research Strand Is About?

This research strand looks at the many ways in which climate change can affect the prices of equity and debt assets, via the distinct channels of transition and physical climate risk.

 

The Size-of-the-Pie Effect

The aim of the first line of research in this strand is to ascertain which aggregate output losses one can expect from climate change and from our response to it. These aggregate losses affect valuation by reducing the cashflows available for the holders of securities. It is a size-of-the-pie effect: as the pie is reduced, so will, on average, the slices that can be carved from it. State-of-the-art Integrated Assessment Models are used for the task.

 

Sectoral Effects

Equally, if not more, important are the sectoral effects of the decarbonization transition. Even if a diversified portfolio may suffer limited climate-related losses (because of the gains among winners compensating for the losses among phased-out sectors), one can expect a major reallocation of investments and a major revaluation across sectors. A second line of research is therefore devoted to this sectoral analysis.

 

The Climate Beta

Apart from a few obvious cases, it is a moot empirical question which sectors will benefit and which will suffer from a green transition. The estimation of this ‘climate beta’ is an additional research programme in the main strand, and is key to the construction of diversified portfolios, to factor (‘smart-beta’) investing, and to understanding the sign of the risk premium a security will attract. Several investigation techniques (from NLP to statistical techniques and traditional bottom-up analysis) are used for the task.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. 

 

The Climate Risk Premium

A related line of research is focussed on the estimation of the sign (and, if possible, the magnitude) of the climate risk premium. It is not immediately clear whether climate losses are more likely to be incurred in periods of low or high economic activity, and this will determine the sign of the climate risk premium. An understanding of a security’s exposure to the climate risk factor, and of the degree of compensation that this exposure attracts is of key importance for climate-aware investing.

 

Climate Risk and Financial Crises

Asset prices can be affected (at the aggregate or sectoral level) not only by fundamental shocks, but also by the reverberations of financial crises onto the real economy. This raises the question of whether and to what extent climate-related losses (physical or regulatory) can stress the portfolios of Systemically Important Financial Institutions (SIFIs) and sow the seeds for banking crises. The focus of this line of research is therefore on the identification and quantification of the exposure of the portfolios of banks and other SIFIs to climate-vulnerable assets, and on the existence or otherwise of conditions (such as leverage, concentration and synthetic exposure) that can make these institutions particularly fragile.

 

Stress Testing and Scenario Analysis

The possible outcomes for the economy and asset prices are best explored via scenario analysis and, from a prudential perspective, stress testing. An important line of research of the first strand is therefore devoted to the application of state-of-the-art techniques (such as Bayesian nets) to explore a range of plausible and possible outcomes.

This line of research organically links with the second major research strand, which looks at how finance can influence the decarbonization transition.

 

Riccardo Rebonato, EDHEC Risk Climate Impact InstituteThe programme Impact of Climate Change on Asset Prices and Investment Management is led by Riccardo Rebonato, Professor of Finance at EDHEC Business School, a specialist in interest rate risk modelling with applications to bond portfolio management and fixed-income derivatives pricing. He was previously Global Head of Rates and FX Research at PIMCO. He has published extensively on the use of Bayesian nets for stress testing and asset allocation. His past academic experience in the hard sciences (physics & nuclear engineering) is a unique asset in the adaptation of the existing IAMs to the task at hand.