Research and publications

How Does Climate Risk Affect Global Equity Valuations? A Novel Approach

This research examines the impact of climate change-induced transition costs and physical damages on global equity valuation by pricing equity as the sum of discounted ...

Author(s):

Riccardo Rebonato, Dherminder Kainth, Lionel Melin

Summary:

This research examines the impact of climate change-induced transition costs and physical damages on global equity valuation by pricing equity as the sum of discounted claims on consumption across climate and economic scenarios consistent with different greenhouse gas emissions trajectories.

Methodological Contributions:

This work innovatively combines asset pricing techniques with an upgraded integrated climate economics model. It benefits from three distinctive methodological innovations:

  • Full Probabilistic Treatment: We rigorously address the uncertainty inherent in both the physical and economic dimensions of the problem.
  • State-Dependent Discounting: We incorporate this crucial but often overlooked aspect of valuation, highlighting its importance.
  • Integrated Analysis of Transition Costs and Physical Damages: Our coherent framework contrasts with traditional approaches that analyze these impacts separately and often inconsistently.

The probabilistic treatment is essential because the damages obtained with average climate outcomes are not the same as the average of damages across different climate scenarios. State-dependent discounting is critical, as we demonstrate that the highest climate damages are correlated with economic activity levels, which, in turn, influence prevailing interest rates. A joint treatment of transition costs and physical damages is necessary because these two factors are intimately and inversely related, requiring consistent estimation.

Key Results:

Impact of Abatement Policies

1. A robust abatement policy, i.e., roughly speaking, a policy consistent with the 2°C Paris-Agreement target, can limit downward equity revaluation to 5-to-10%.
2. Conversely, the correction to global equity valuation can be as large as 40% if abatement remains at historic rates, even in the absence of tipping points.

Role of Tipping Points

3. Tipping points exacerbate equity valuation shocks but are not required for substantial equity losses to be incurred.

Importance of Physical Damages

4. When state-dependent discounting is used for valuation, physical damages, even if ‘back-loaded’, are not fully ‘discounted away’, and contribute significantly to the equity valuation.

Conservatism and Limitations:

While estimated revaluations are often more severe than those reported in the literature, the valuation is based on conservative choices. First, modeled losses are limited by the counteracting effect of lower rates in states of reduced economic activity. While this parallels typical actions of monetary authorities, there are practical circumstances that could limit the ability of central banks to adopt such an accommodative stance, e.g., excessive inflation or accumulated public deficits. Second, the analysis is centered around relatively benign functions to map temperature increases to economic damages. Finally, while the analysis treats equity dividends as leveraged claims on consumption, it adopts the lowest leverage used in the literature, which dampens the sensitivity of equity values to economic shocks.

 

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Type : EDHEC Publication
Date : 10/07/2024