Riccardo Rebonato invited to discuss climate stress tests in Moody’s podcast
Written on 07 Dec 2023.
Short-term climate stresses and long-term expectations: Are markets asleep at the wheel?
Riccardo Rebonato, Scientific Director at EDHEC-Risk Climate Impact Institute and Professor of Finance at EDHEC Business School, was invited by Nick Jessop, Head of Scenario Modelling Research, Insurance and Pension at Moody’s Analytics, to participate in the 2nd episode of their podcast series hosted by The Actuary, titled “Exploring climate change modelling for insurers”. The series addresses the expectations and challenges of performing adequate analysis on both assets and liabilities, and the practical applications.
In this 30-min conversation hosted by Christian Doherty (The Actuary), climate experts engage in a thought-provoking discussion, exploring how standard climate scenarios, such as those produced by the Network for Greening the Financial System (NGFS), can be used to create short-term stresses for financial markets and broaden the scope of climate analysis. Key issues addressed include:
- Do current asset prices reflect the realities of the impact of climate change?
- Are existing models and scenarios focusing on the right areas and capturing the true impact?
- Have scenarios been adequately understood and modeled?
- When will the market stop being asleep? What will be the wake-up call?
Professor Rebonato shares insights on these topics, expressing his conviction that current asset prices only partially reflect the effects of climate change. He emphasizes the significant uncertainty surrounding the economic impacts of climate change and discusses the potential reasons behind the market's apparent underreaction. Below are some of the key points shared by Professor Rebonato during the episode:
Prices, if they reflect the effect of climate change, they only do so in a very partial way. Why do I think so? Well, there have been lots and lots of studies that have tried to detect whether prices move in response to climate change news to detect any kind of the climate risk premium. And the results are very, very, what they're called statistically significant. So it's good enough to publish a paper, but economically not significant.
One possibility would be that the market thinks that adaptation and abatement and everything will be so effective that climate change will be a known issue. We'll be able to manage it very well. And the other thing is that you might think that even without doing anything there will be a soft landing.
What I would like to stress is the degree of uncertainty about what damages will be is absolutely huge. So admittedly there are some serious estimates that say the economic effects (I'm stressing economic effects) of climate change might not be very big. Other estimates say they will be disastrous. The range of uncertainty is such that it should be reflected in the prices. After all, what modern finance teaches us is that prices are not just a function of expectations, what we expect the cash flows to be, but also a function of uncertainty. And as we increase the uncertainty, our asset allocation changes, the prices change, etc. And we are not seeing this...
The creators of the narrative, the SSP and the RCP narratives, they can call them whatever they want, but what is important is how they are used and what interpretation is given to this. Now, these narratives and these representative carbon pathways were not created with investors in mind; they were created with policy in mind. So a recognition of the probability of a different outcome, which is completely missing from the present architecture, is essential in order to draw reasonable investment conclusions.
So there are a lot of misunderstandings. The quality of the work that went into creating these scenarios is excellent, but they were created with different purposes in mind, and the moment they are uncritically used by investors, they can be not fit for purposes. And I would say more, they could be dangerous, especially in their lack of communicating uncertainty around central estimates.
The academic community and the policy board, etc., have to provide better scenarios. However, there also has to be a different type of engagement from big institutional investors.
The episode also highlights Professor Rebonato’s latest research, published in the 2023 special issue of The Journal of Portfolio Management on Novel Risks, titled "Asleep at the Wheel? The Risk of Sudden Price Adjustments." In this research, he explores the emergence of climate risks as new factors influencing asset prices, considering the potential underestimation of the effects of long-term physical climate risk on the cash flows of companies and government revenues, along with the risk of repricing.
About EDHEC
Operating from campuses in Lille, Nice, Paris, London and Singapore, EDHEC is one of the world’s top 15 business schools. Fully international and directly connected to the business world, EDHEC commands a strong reputation for research excellence and the ability to train entrepreneurs and managers capable of breaking new ground. EDHEC functions as a genuine laboratory of ideas and produces innovative solutions valued by businesses. The School’s teaching is inspired by its research work and a focus on “learning by doing”, all with the aim of equipping people with the skills to succeed in business.
