Only 18% of financial decision-makers think climate risk is appropriately priced into markets, according to new academic research.
Finance professors in the Netherlands asked nearly 2,000 members of the Chartered Financial Analyst (CFA) Institute whether they encountered the issue of climate risk in their daily work, and 60% said they did.
Asked if they thought these risks were priced sufficiently in current markets, 68% said no, while 14% said climate risk was overpriced and 18% said current levels were adequate.
The participants were also asked whether they expected a climate equity index to outperform its benchmark over the coming year and decade.
The group was split quite evenly between those who believed the MSCI World Climate Action index would beat, underperform or mirror the MSCI World over 12 months. But around 60% believed it would outperform over the next 10 years.
“We then looked at what mental models were behind these return expectations,” explained Rob Bauer, a professor of finance at Maastricht University School of Business and Economics, who co-authored the research.
There were two dominant mindsets: one was a belief that current data is not robust enough to provide meaningful visibility on climate risk. The second was linked to what others in the market believe.
“A typical European financial analyst might think they are ahead when it comes to understanding climate risks, compared with the broader market, and therefore can make money from that knowledge,” said Bauer.
“Whereas an American analyst is more likely to believe that European peers have overemphasised the issue, inflating prices; so they might have negative return expectations [for the MSCI Climate Index],” he added.
Political measures were also cited as an influence on thinking.
The final part of the study involved creating concentrated groups of respondents and presenting each group with a different set of information about what their peers thought.
“We told one group that other CFA charter-holders believe climate risks are not sufficiently reflected in prices, and another group something similar on the opposite side – that some charter-holders think climate risk is sufficiently reflected or reflected too much in prices,” Bauer said.
The purpose was to see if shifting the perception of what other experts believe could also shift a financial expert’s return expectations. At the end of the study, participants were asked if they would like to update the beliefs they stated at the start.
“There is a huge difference in the response of those two groups – they were heavily influenced by the information we presented them in that final experiment,” Bauer noted, adding that respondents in both groups were more likely to align themselves with the beliefs they had been shown during the experiment, when it came to expected returns over the next 12 months.
“Which demonstrates that what investors believe on climate is influenced by what they think others believe,” he continued.
Bauer said the research highlighted the need for capital allocators to understand the mental models driving the decisions of their internal and external managers and analysts.
“The research shows that there is a lot of difference in opinion about whether equity markets are properly priced, whether climate risk will drive returns, and even whether it’s important in the first place,” he said.
“Asset owners should be trying to understand what that looks like, and ensure they capture that diversity of thought. And decision-makers should realise that, in the context of climate risk, they are not the only ones that are knowledgeable.”
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