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.