New research suggests that more than 40% of global equity value risks being wiped out by climate change, and could make corporate debt a more appealing asset class for investors.
Analysis by France’s EDHEC Business School has concluded that, under a business-as-usual scenario – where only incremental policy interventions are made to manage the impacts of climate change – equity losses could surpass 50%.
“Prompt and robust abatement action is needed to keep losses below 10%,” the research concluded.
The paper – How does climate risk affect global equity valuations? A novel approach – uses a series of ‘probabilistic’ scenarios, plotting different potential trajectories for climate policy and emissions.
“It combines physical climate risks with the cost of the climate transition, to establish possible impacts on equity valuations,” explained Ricardo Rebonato, scientific director of EDHEC’s Climate Impact Institute and lead author of the report.
Given that physical risks are expected to increase if governments do not intervene with strong climate policies, there is a perceived inverse correlation between the two.
“They should therefore be looked at in conjunction,” said Rebonato. “Which makes a lot of intuitive sense, but in reality is rarely done”.
Using the scenarios, the study explores the relationship between climate change, state-dependent discounting – including interest rate decisions – and the performance of a hypothetical global equity index.
It also looks at the impact of different environmental tipping points, which would trigger abrupt shifts in behaviour, ecosystems, resources or policy.
“The magnitude of losses depends on the aggressiveness of emission-abatement policy; the presence or otherwise of tipping points; on the extent of central banks’ willingness and ability to lower rates in states of economic distress,” it explained.
Speaking to IPE, Rebonato said the findings had implications for investors’ asset allocation decisions.
“It suggests we are entering a scenario in which there will be a hit exactly to the junior part of the capital structure. And as the downside begins to outweigh the upside, the more senior part of the capital structure becomes increasingly attractive, meaning corporate debt.”
Rebonato added that investors should ensure the bottom-up analysis they often use to help understand the potential impact of climate change on different sectors stacks up against top-down analysis.
“Calculations for equity impairments at sector level are likely to add up to less than if one looks at damages across the whole economy,” he noted, “because there are things that cannot be captured by looking at sectors individually.”
The impact of policies and weather events on an airline’s ability to continue to fly planes, for example, should be accompanied by more macro-analysis of the impact of lowered GDP on demand for flights.
“There are pieces investors are not seeing,” noted Rebonato.
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