Professor Riccardo Rebonato: “A significant risk re-pricing may be overdue"

The scientific director of the EDHEC-Risk Climate Impact Institute and a professor of finance, tells Andrew Holt about why he is encouraged by efforts to address climate change, but says institutional investors should move from ‘canned scenarios’ and raises issues about carbon removal.

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Portfolio Institutional 24/07/2023

Portfolio Institutional

"(...) There is no doubt that emission abatement must play a key, and increasingly important, role in controlling climate change. Investors can play a significant part in this respect. However, every scientist and the Intergovernmental Panel on Climate Change agree that all paths to a manageable level of warming by the end of the century require substantial carbon removal. Unfortunately, we have very few practical carbon removal options, such as afforestation and reforestation, that can be deployed in scale now. Even the ones that we do have are no panacea, for instance, because of competition for land from afforestation. Other removal technologies are expensive and require a lot of energy that must be provided by renewables unless we want to use up our carbon budget (...)

(...) All risk premia depend on whether the security in question pays well or badly when we feel rich or poor. Equities attract a positive risk premium because an equity portfolio pays badly when the whole economy is in the doldrums. Investors do not like these ‘fair-weather friends’ and, therefore, pay less for them – lower price, higher expected return. Conversely, US treasuries and bonds attracted a negative risk premium up to the Covid crisis because they were perceived as providing a hedge to equity wobbles: the ‘Greenspan put’ – that is, to act as insurance by performing well when the rest of the portfolio was doing poorly. So, the same expected cashflows can be valued differently if they materialise in good or bad states of the economy.

Investors should care a lot about this because the risk premium can be a substantial part of the expected return from an asset. Indeed, part of the current high treasury yields in the US and the UK are due not just to inflation expectations but also to the fact that the negative risk premium has evaporated.

This has happened because investors are no longer willing to pay an ‘insurance premium’ because the insurance policy doesn’t seem to work anymore (...)

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Professor Riccardo Rebonato: “A significant risk re-pricing may be overdue", 24/07/2023