Winter of Despair, Spring of Hope

This edito by Frédéric Ducoulombier, Founding Director of EDHEC-Risk Climate, has been originally published in the inaugural newsletter of the Institute. To subscribe to this complimentary newsletter, please contact: [email protected].

EDHEC-Risk Institute was established in 2001 to conduct academic research on defining risk and investment management issues. Our aim is to highlight its practical implications and applications to end investors and their service providers. The Institute has played a notable role in articulating and ushering in paradigm changes to investment and pension management that enable investors to achieve higher risk-adjusted performance at lower cost. We initiated coverage of the integration of sustainability issues into investment some 15 years ago, directly contributing to responsible investment by foresighted institutional investors. Our shift in focus, including our change of name to EDHEC Risk Climate Impact Institute, reflects the mainstreaming of sustainability issues by the finance industry. This transition also signals the commitment of EDHEC Business School to advancing the integration of sustainability imperatives across economic activities. 

EDHEC-Risk Climate’s mission is to help private and public decision makers manage climate-related financial risks and make the best use of financial tools to transition to low-emissions and climate-resilient economies. Our core ambition is to become a leading academic reference, helping long-term investors manage the asset pricing implications of climate change. Strategic asset allocation, portfolio-construction and risk management under climate change risk are central issues for the traditional constituencies of EDHEC Risk Institute. We also aim to play a leading role helping financial supervisors and policy makers assess climate-related risks in the financial system and advise on policy and tools in order to mitigate those risks and optimise the contribution of finance to climate change mitigation and adaptation.

In this editorial, founding Director Frédéric Ducoulombier, CAIA, introduces our main research orientation in the context of the climate emergency.

It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of light, it was the season of darkness, it was the spring of hope, it was the winter of despair, we had everything before us, we had nothing before us, we were all going direct to heaven, we were all going direct the other way–in short, the period was so far like the present period, that some of its noisiest authorities insisted on its being received, for good or for evil, in the superlative degree of comparison only. A Tale of Two Cities, Charles Dickens, 1859.

The reality of economic-activity-induced climate change, long supported by an overwhelming scientific consensus,[i] is now so firmly accepted by the general public[1] that parties opposing climate action have switched focus from denying its existence to providing excuses for delaying action[ii]. Sadly, acceptance of the reality of climate change by the population has been prompted by the rise in weather and climate extremes across the world causing unprecedented natural, economic and human losses.

Most of the parties to the 1992 United Nation Framework Convention on Climate Change (UNFCCC) have established adaptation plans, but while adaptation investments have progressed, they remain insufficient – catastrophically so in developing countries[2]–and are increasing at a pace that does not keep up with rising challenges. Abatement commitments taken by parties to the 2015 Paris Agreement (so-called Nationally Determined Contributions) have been upped, but policies to make good on these promises have yet to materialise in all but a few jurisdictions and global emissions of greenhouse gases haves scaled new heights.

Rapid, deep, and sustained reduction in greenhouse gas emissions are required to reduce the risk of crossing thresholds that could trigger irreversible high impact events, or tipping points, and to preserve the possibility of halting or reversing global warming in the second half of the century. In this regard, the latest synthesis report of the Intergovernmental Panel on Climate Change (IPCC, 2023) mentions a “rapidly closing window of opportunity to secure a liveable and sustainable future for all”, highlights the benefits of bold action this decade, and insists that the necessary changes can be implemented in an inclusive and equitable manner.

Humanity is at a junction. The track record of political inaction; the power of vested interests; the weight of our legacy infrastructure – these all provide excellent reasons to despair.[3] However, other developments also offer glimmers of hope:[4] legislative progress; the first successes of climate litigation and climate equity and growing support for bold climate action[5]; and the emergence of resources-efficient technologies and green economic interests.

While emissions trends and announced short-to-medium-term mitigation action plans make it highly likely that the 1.5°C of global warming will be breached in the course of this decade or the next, a fundamental reorganisation of the global economy could still reduce future damage, support restorative activity, and support a transition towards reasoned management of resources consistent with the long-term viability of human civilisation.

Emissions mitigation and climate change adaptation would require major funding – the flows are not materialising at the scale needed as governments are neither directing these investments nor providing coherent policy and regulatory signals that may prompt private actors to undertake these investments[iii] and the uncertainty about the policy response further reduces the number of projects with a positive net present value. The lack of coherent signals is also hampering the ability of economic agents to manage the risks arising from climate change.

In this context, there is a lot that financial economists and an applied finance research centre like EDHEC-Risk Climate can do. Focusing on our main research axis, i.e., the exploration of the impact of climate change on asset pricing and investment management,[6] this includes:

• Bringing clarity to decision makers about the cost of action and inaction;
• Helping long-term investors evaluate the potential economic and financial impacts of various pathways of mitigation of, and adaptation to, climate change;
• Helping non-financial corporations and investors integrate climate change dimensions into decision making to adjust activity/investments to expectations and increase resilience to risks.

As things stand, the needs are considerable. 

Indeed, models needed to measure and manage the financial risks from climate change are still in their infancy and much needs to be done to extend and repurpose these tools to make them relevant for asset pricing. This is the journey EDHEC-Risk Climate has set upon.

Schematically, there are two types of tools in use at the moment: top-down integrated assessment models (IAMs) which have been used to inform on optimal economic policy in the face of climate change; and (mostly) bottom-up stress testing tools which have been used to quantify the impact of climate scenario realisations on asset prices.

IAMs combine models from climate science, energy systems, and economics to study the interactions between the physical and human systems in the context of climate change. Their aim is to inform policy by determining the optimal course of action to counter the effects of climate change and assessing the costs, benefits, and uncertainties of different pathways and strategies. While traditional implementations of IAMs were not adapted for financial applications, the research team led by EDHEC-Risk Climate Scientific Director Professor Riccardo Rebonato has made breakthrough contributions to produce a version of the Dynamic Integrated Climate-Economy model that is consistent with asset pricing and also incorporates the latest advances of climate science. This new tool produces very useful policy guidance – incidentally, it finds that Paris Agreement-type global warming mitigation targets can be justified as economically optimal. It also helps investors understand what the repercussions of optimal or sub-optimal policies on asset prices may be and inform analysis of current prices and outstanding risks. The tool links climate risk to asset pricing via two channels: cashflow expectations and risk premia.

The bottom-up risk assessment tools offered by data and analytics providers and the methodological framework used by financial institutions conducting stress tests (which are often inspired by the seminal climate stress testing work of our research programme manager Professor Irene Monasterolo) ) characterise changes in economic conditions facing different industries given certain realisations of climate change risks to measure the economic and financial impact at the level of a firm relative to a baseline scenario and the impact on the financial liabilities of the firm. This enables the impact on the value of the debt and equity of the company to be modelled, and by extension the impact on the investors holding these assets. The impact of these shocks on the balance sheets of banks is the focus of the nascent prudential exercises being performed by central banks. Data and analytics providers suggest investment portfolio managers may use such tools to measure and improve portfolio resilience to potential shocks. We consider these tools as useful first steps, especially when their assumptions derive from climate scenario trajectories produced by IAMs. However, this framework was not designed for asset pricing – valuation is conditional and probability naïve – and the approach inherits the limitation of the scenarios used: determinism, focus on average realisations, and for some reference scenarios excessive optimism. EDHEC-Risk Climate will be working on extending and repurposing scenario analysis to account for the variability of climate and economic realisations within scenarios while integrating the bottom-up and top-down approaches, to promote adoption of sets of scenarios that better capture the range of possible trajectories of climate change and climate change action, and to attach probabilities to scenarios.[iv]

Once this repurposing has been performed and fundamental asset pricing questions have been answered, which is of the essence to both corporate CFOs and investors, we will be in a position to probe the extent to which diversification and hedging are possible and investigate whether current prices appear to correctly reflect climate risks.

As for market-based estimation of asset sensitivities to climate risks, EDHEC-Risk Climate researchers have been working to extend state-of-the-art approaches – and we are delighted to be in a position to present work directed by our colleague Professor Dominic O’Kane in the context of a research chair supported by Amundi AM. The research employed novel techniques and notably Natural Language Processing and evidences a statistically significant equity price reaction to climate change related news. However, it is consistent with previous studies of market prices in its documentation of an effect of modest economic significance. When contrasted with the early results of our top-down modelling approaches [to be discussed at our forthcoming webinar titled: Where is the Climate Risk Premium?], it hints at a significant risk of repricing.

Footnotes

[1] A 2020 survey of 1.2 million people in 50 countries found that 64% of respondents believe that climate change is a global emergency (UNDP and University of Oxford, 2021).

[2] In 2009, rich countries promised to channel USD100 billion a year to less wealthy nations by 2020. This promise was broken. According to the latest report of the United Nations Environment Programme (2022), the gap is likely 5-10 times greater than current international adaptation finance flows and continues to widen.

[3] Certainly, the track record of inaction on the part of governments; the stronghold of ideological options that have fuelled the acceleration of the climate crisis in the past 40-some years; the remarkable propaganda and political capture successes achieved by powerful vested interests opposing climate action over the same period; the stark differences of exposures to the consequences of climate change and climate change action along wealth, generational, sector and country lines; but also the sheer weight of the resources-intensive legacy infrastructure – both physical and cultural – that needs to be retired – are all rational causes of heightened eco-anxiety and can easily lead to distress and despair among those who are most at risk and also appear to be least in a position to productively challenge the direction of the world. Negative coping mechanisms may provide temporary relief from these difficult emotions – some of the same mechanisms and a few more (e.g., denial, rationalisation, minimisation, projection) are available to help those who have clear responsibility and agency avoid or minimise the psychological discomfort associated with the support of a status quo which they know or (may have been cowed to) believe better serves their interests.

[4] However, there are also reasons to feel cautiously hopeful about our collective ability to face the challenges ahead in a manner that protects and possibly enhance the welfare of the largest number. There are recent positive developments that may energise and inspire individuals to engage in and support meaningful action towards environmental sustainability. In this regard, one may cite the progress of legislative proposals that would align policies with state commitments, which is most visible in the European Union; the recognition of environmental externalities as market failures calling for regulation, renewed interest in alternative measures of well-being and development, increased questioning of the ends and means of economic organisation and organisations, and advocacy of sustainable development within planetary boundaries; the surge of progressive climate litigation worldwide and the first successes against states, local authorities, and companies – often brought about by the weakest of the weak; growing minority support for bold climate action, notably in the more developed countries (along with changing social norms and emerging behavioural shifts) and the breakthrough decision to establish a Loss and Damage fund taken at the latest Conference of the Parties to the UNFCCC (CoP27); the emergence of resources-efficient technologies that are economically competitive despite the systemic benefits and subsidies enjoyed by resources-intensive approaches and the first lobbying successes of established green economic interests and environmental non-governmental organisations.

[5] Among the 64% of people who said that climate change is a global emergency in the UNDP and University of Oxford (2021) survey, 59% said that the world should do everything necessary and urgently in response – in high income countries and small island developing states, the figure was 70%.

[6] Considering the impact of finance lato sensu on climate change mitigation and adaptation is our secondary research orientation. In addition to our research agenda, our policy advocacy function ambitions to assist regulators and standard makers in producing rules and norms that are fit for the purpose of improving information about climate change risks and facilitating the necessary financial flows required to transition towards low-emissions and climate-change resilient economies.

References

Avery, S. K., Try, P. D., Anthes, R. A., Hallgren, R. E. (1996). An open letter to Ben Santer, Special Insert, UCAR Quarterly, Summer 1996.
Charney, J. G., Arakawa, A., Baker, D. J., Bolin, B., Dickinson, R. E., Goody, R. M., Leith, C. E., Stommel, H. M., Wunsch, C. I. (1979). Carbon Dioxide and Climate: A Scientific Assessment, National Academy of Sciences, National Research Council.
Environmental Pollution Panel President's Science Advisory Committee (1965). Restoring the Quality of Our Environment, The White House (November).
IPCC (1990, 1992). First Assessment Report Overview and Policymaker Summaries and 1992 IPCC Supplement, Intergovernmental Panel on Climate Change, Canada, 178pp.
IPCC (1996). Climate Change 1995 – The Science of Climate Change – Contribution of WGI to the Second Assessment Report of the Intergovernmental Panel on Climate Change, Intergovernmental Panel on Climate Change, Cambridge University Press, Cambridge, UK and New York, NY, USA,  588pp.
IPCC (2022). Climate Change 2022: Impacts, Adaptation and Vulnerability. Contribution of Working Group II to the Sixth Assessment Report of the Intergovernmental Panel on Climate Change [H.-O. Pörtner, D.C. Roberts, M. Tignor, E.S. Poloczanska, K. Mintenbeck, A. Alegría, M. Craig, S. Langsdorf, S. Löschke, V. Möller, A. Okem, B. Rama (eds.), Cambridge University Press, Cambridge, UK and New York, NY, USA, 3056 pp.
IPCC (2023), Synthesis Report of the IPCC Sixth Assessment Report (AR6) – Summary for Policymakers, Intergovernmental Panel on Climate Change.
Johnson, L. B. (1965). Special Message to the Congress on Conservation and Restoration of Natural Beauty (8 February).
Lamb, W., Mattioli, G., Levi, S., Roberts, J., Capstick, S., Creutzig, F., Minx, J. C., Müller-Hansen, F., Culhane, T., and Steinberger, J. (2020). Discourses of climate delay. Global Sustainability, 3, E17.
Painter, J., Ettinger, J., Holmes, D., Loy, L., Pinto, J., Richardson, L., Thomas-Walters, L. , Vowles, K, and Wetts, R. (2023). Climate delay discourses present in global mainstream television coverage of the IPCC’s 2021 report. Communications Earth and Environment, Volume 4, Article 118.
Supran, G., Rahmstorf, S., and N. Oreskes (2023). Assessing ExxonMobil’s global warming projections, Science, Vol. 379, Issue 6628.
United Nations Development Programme and University of Oxford (2021). Peoples’ Climate Vote – Results (January).
United Nations Environment Programme (2022). Adaptation Gap Report 2022: Too Little, Too Slow – Climate adaptation failure puts world at risk. Nairobi.

[i] In a Special Message to Congress sent shortly after his inauguration, US President Lyndon Baines Johnson (1965), underlined that man had “altered the composition of the atmosphere on a global scale through radioactive materials and a steady increase in carbon dioxide from the burning of fossil fuels” – a November 1965 report of the President’s Science Advisory Committee titled Restoring the Quality of our Environment includes a chapter on Atmospheric Carbon Dioxide and its consequences in terms of warming and sea level rise, along with a rather accurate forecast of concentration by the end of the century (the lead author for the chapter was Doctor Roger Revelle, the former director of Scripps Institution of Oceanography and founding director of the Harvard Center for Population and Development Studies. In a 1957 article, Doctor Revelle had demonstrated that the atmospheric increase in carbon dioxide resulted from the consumption of fossil fuels, and his research was associated with the first use of the term global warming). Global warming predictions remained disputed however.  In 1979 (also the year of the first World Climate Conference), the US National Academy of Sciences asked a group of scientists led by MIT Professor of meteorology Jule Charney to review the evidence – the Charney report concluded that if carbon dioxide continued to accumulate in the atmosphere, there were “no reason to doubt that climate changes will result” and estimated “the most probable warming for a doubling of CO₂ to be near 3℃ with a probable error of 1.5℃."This was remarkable and many of the findings of this review are still valid. The same is true of the internal projections made about the same time by leading fossil fuel industry companies such as Exxon (see Supran et al, 2023 and the references in the work of Dr Benjamin Franta). In the 1980s, conferences organised under the aegis of the United Nations reviewed the evidence and recommended setting up an expert group to keep track of climate science and produce periodic syntheses to be approved by member states. This led to the creation of the Intergovernmental Panel on Climate Change whose first report concluded that it was a certainty that “emissions resulting from human activities are substantially increasing the atmospheric concentrations of the greenhouse gases” which will enhance the greenhouse effect, “resulting on average in an additional warming of the Earth's surface.” (IPCC, 1990 and 1992). The second assessment report included a chapter on the Detection of Climate Change and Attribution of Causes that justified the inclusion of the following historic conclusion in the executive summary: “The balance of evidence, from changes in global mean surface air temperature and from changes in geographical, seasonal and vertical patterns of atmospheric temperature, suggests a discernible human influence on global climate.” (IPCC, 1996). The oil and gas industry mobilised against this chapter accusing the lead author of fraud leading the executive committee of the American Meteorologist Society and the trustees of the University Corporation for Atmospheric Research to publish an open letter containing this language: “There appears to be a concerted and systematic effort by some individuals to undermine and discredit the scientific process that has led many scientists working on understanding climate to conclude that there is a very real possibility that humans are modifying Earth's climate on a global scale. Rather than carrying out a legitimate scientific debate through the peer-reviewed literature, they are waging in the public media a vocal campaign against scientific results with which they disagree.” (Avery et al., 1996). This disinformation campaign was hugely successful at presenting consensual scientific knowledge as controversial in the eyes of the public and at facilitating the delay of meaningful climate change action by politicians – attacks of vested interests against climate science and climate scientists continue and so does the capture of lawmakers. For the first time, the latest IPCC report acknowledges the role of vested interests in delaying climate action: “Despite scientific certainty of the anthropogenic influence on climate change, misinformation and politicisation of climate-change science has created polarisation in public and policy domains in North America, particularly in the USA, limiting climate action (high confidence). Vested interests have generated rhetoric and misinformation that undermines climate science and disregards risk and urgency (medium confidence). Resultant public misperception of climate risks and polarised public support for climate actions is delaying urgent adaptation planning and implementation (high confidence).” (IPCC, 2022).

[ii] Lamb et al. (2020) identifies common forms of climate delay discourses which they categorise into those that: “(1) redirect responsibility; (2) push non-transformative solutions; (3) emphasize the downsides of climate policies; or (4) surrender to climate change.” Painter et al. (2023) analyse television coverage of the 2021 IPCC report and find that “skepticism about the science of climate change is still prevalent in channels (…) classified as ‘right-wing’, but largely absent from channels classified as ‘mainstream’. (…) Two of the most prominent discourses question the perceived economic costs of taking action and the personal sacrifices involved.”

[iii] While the negative externalities that have led us to the brink of civilisational collapse have been identified, they have not been corrected. While global carbon pricing revenue increased to an all-time high of USD84bn in 2021, less than 4% of global emissions were then covered by a direct carbon price within the range needed by 2030 according to the World Bank. In 2022, direct subsidies to the consumption of fossil fuels doubled from the previous year to an all-time high in excess of USD1 trillion according to the latest estimates of the International Energy Agency – the total support to fossil fuels would need to account for indirect subsidies and production subsidies.

[iv] With regards to scenarios, it is important to underline that current reference scenarios are very long-term in nature, whereas it is to be expected that bold action in the course of this decade – while mitigating long-term physical risks – would generate considerable transition risks. The Network for Greening the Financial System is aiming to produce short- and medium-term scenarios by the end of 2024 for prudential exercises. We are building capacity to improve the modelling of front-end transition shocks across sectors and borders through research on global supply chains and down to the asset level in the context of joint work on technological transition pathways with sister research centre EDHEC Infrastructure & Private Assets Institute.