Is Climate Risk More than Markets Can Handle?

Q: What role do financial markets have in addressing climate change?

One of the primary roles of financial markets is to share risks, so markets could play a key role. There are challenges because of the complexity of the risks and the timeframes of impacts—the most devastating impacts could take 50, 100, or 200 years to show up. But fundamentally there’s nothing that would prevent financial markets from sharing climate risk. Markets have been hedging other macro risks for a long time.

When we talk about sharing risks, we’re mostly talking about various forms of insurance. And right now, if you are worried about climate change, you cannot buy insurance to protect yourself.

We need a broader portfolio of tools to cover these new risks. I think that will come from adapting existing options and developing new ones. For example, the World Bank has been helping countries issue catastrophe bonds against natural disasters like earthquakes. These could be expanded to specifically address climate risks..

Q: Why aren’t markets offering ways to share climate risk already?

Financial markets work very well dealing with risks that we understand. Markets struggle when dealing with a very, very large amount of uncertainty. What’s the probability of a certain level of sea rise? What’s the probability of a certain policy response? How will those big pieces—the physical processes associated with climate impacts and the national and international policy responses—interact with the economy?

With so much complexity and uncertainty, it’s very hard for people to take any side of the risk. If you’re betting on a stock or if you’re selling insurance against climate risk, you might just get it completely wrong because you couldn’t properly assess the probability. That makes people afraid of taking large positions which impedes financial markets from working well. We need people on both sides for markets to work.

Despite the uncertainty, I think financial markets do have a role to play. They can mitigate some of the climate impacts by helping funds move from polluting technologies to green technologies. And a transition to a more sustainable economy will require a lot of information. Financial markets are very good at aggregating information about what’s expected as well as people’s preferences about dealing with the risks.

Q: A recent analysis of peer-reviewed scientific literature found that there’s greater than 99% agreement among scientists that greenhouse gas emissions from human activity is driving climate change, yet outside the scientific world there’s still skepticism. Does inaccurate information about climate change shift markets?

Markets aggregate the beliefs and practices of people. If people are just very wrong, then markets reflect that. That’s always a problem with financial markets. If you go back 15 years, the scientific community was already very aware of the risk of climate change, but financial markets didn’t seem to incorporate it at all.

In recent years, there has been a great deal of work, some of which I also participated in, trying to understand to what extent markets are incorporating information about climate risks. If we want to use financial markets to manage these risks, it’s crucial that there is a certain level of awareness in the markets.

A wide range of studies have shown that climate risk is now priced in financial markets—equities, corporate bonds, municipal bonds, stocks, and real estate. That’s a very important starting point. And I think it’s reassuring. But I cannot tell you whether it’s properly reflected from a quantitative standpoint. Nobody can say that because we don’t know how much it should affect the price of an asset. We don’t have a counterfactual, so we can only tell you that climate risk is somewhat reflected.

Q: Investors have shown a great deal of interest in environmental, social, and governance (ESG) metrics, in part to understand companies’ exposure to climate change. Is ESG data important?

Without good information financial markets cannot operate properly, so I think it’s very important that firms disclose ESG information. It’s a critical part of how we go forward.

Understanding investors preferences for ESG is also important for understanding financial markets’ reaction to climate change. In one branch of my research, I’ve been interviewing investors and looking at their portfolios to see how people act on their beliefs when building portfolios. It’s an incredible window inside people’s minds.

One of the things that we’re studying is how they perceive ESG investing, which may help us understand whether ESG investing itself is sustainable. You can imagine if most ESG investors choose ESG portfolios with the expectation that they will outperform the market, they’re probably going to be disappointed, so they might pull their investments out.

Our findings are still preliminary, but on average investors expect a slightly lower return on ESG portfolios than on standard diversified stock portfolios. That includes about half of the investors surveyed who don’t see any reason to invest in ESG. The remaining investors break down as follows: About a quarter invest in ESG portfolios for ethical reasons. Another 20% see it as a hedge for times when climate risks materialize. Both those categories of investor are expecting lower returns from ESG portfolios. So, it’s only about 5% of all investors that think that ESG stocks will outperform.

Q: Should the ESG information companies provide to investors be voluntary or regulated?

That’s an interesting question. There has been a lot of voluntary collection of data sets on ESG information. As a consequence, there are many, many competing measures of ESG being used. Because they tend to measure different things, the landscape is very noisy, which makes it very hard for investors to really filter out what’s noise and what’s signal.

It could be the solution is simply that we let the competition among the voluntary disclosures keep going. Hopefully the better-quality ones will dominate the market. If that doesn’t happen, some sort of national or global standards for disclosure might be appropriate.

Q: You alluded to the externality issue. Emissions of greenhouse gases are driving climate change. The costs of dealing with the resulting impacts aren’t being paid directly by the producers of the greenhouse gases. It’s a textbook case of an externality. Are there other examples of markets being effective at internalizing externalities?

With externalities, there’s no mechanics through which markets automatically internalize them. Clearly, climate change is a market externality, and we know the tools needed to fix externalities. I think most economists probably agree that the first step would be to implement some sort of global carbon tax (analogous to other Pigouvian taxes like the tax on tobacco, for example). It doesn’t solve all the problems, but it goes a long way toward addressing climate change. However, it’s not clear that a carbon tax is politically feasible. If that’s true, then we need a discussion of what we can do.

Q: What kind of risk does climate change represent to financial markets?

Climate change is a systematic, or aggregate, risk—that is, a risk that cannot be diversified away. But the fact that it’s a systematic risk doesn’t mean that the financial markets are not useful. Inflation, oil prices, and global GDP are all aggregate (systematic) risks, but financial markets are still useful because while the risks cannot be eliminated, they can be transferred to people who are more willing to bear them.

For oil risk, there are people who tend to be naturally on the short side and people who are naturally on the long side. And it’s similar for climate risk. It would be beneficial if some of the risk of the sea-level rise in Bangladesh was shared through financial instruments bought by people in, for example, Switzerland or Utah who are less dramatically affected by this particular type of climate event.

Q: How did you start working on climate finance?

I come from a standard finance background focusing on asset pricing. I’ve looked at questions like, What are the risks that people care about? How do people perceive and manage the risks of fluctuations in financial markets due to uncertainty? How do you build portfolios to manage those risks optimally?

Academic economists have been studying the interactions between pollution and the economy and then global warming and the economic system since the 1970s. But there was initially little consideration of risk, which is where finance plays an important role. Harvard economist Martin Weitzman was the first to really take a financial approach to the risks and uncertainty related to climate change. He opened up that connection. Starting from his work, researchers in finance realized that the tools we have developed can be very directly applied to the climate problem.

For example, I’d been building hedging portfolios for other market risks. Why not for climate? I’d been looking at how people perceive risk over long periods of time in real estate markets. That’s relevant to climate. When we published our paper “Climate Change and Long-Run Discount Rates: Evidence from Real Estate,” policymakers looked at our numbers. I don’t know ultimately what impact this had on specific policies, but I’m glad to feel my work is contributing to solving a very important problem. It’s motivating to be working on questions where I can actually impact lives and society, in a direct or indirect way. I think everybody who does research wants to feel that.

Often in academic research a topic is saturated; we’ve already answered all the major questions and what’s left to discover are minor things. With climate risk, we know almost nothing. Our first paper on a hedging portfolio was an exciting, important step forward. Then you look around and realize, there’s so much we don’t understand. The questions are clear because there are so many gaps in what we know. Slowly we are figuring out better and better ways to fill in the gaps.

Q: Would you explain your work on hedging portfolios?

Our question is: given that we don’t have good financial instruments that are directly tied to climate risk, can we build instruments on our own? Can we figure out which stocks are not exposed to climate risk and which are particularly exposed to climate risk, and bundle them into a long-short portfolio that would go up in value if climate risk materializes and down in value if climate risk does not materialize? If we could do that, it effectively works like a synthetic insurance contract.

A standard way to hedge a risk is to figure out (using historical data) what portfolio would have worked in the past and then replicate that portfolio today. Since markets weren’t paying attention to climate risk even 15 years ago, the long time-series data we’d like to use isn’t available. With my SOM colleague Bryan Kelly and Robert Engle, Heebum Lee, and Johannes Stroebel, who are all at NYU, we developed a first attempt at dynamic hedging that responds to climate change news, using this approach.

In a new paper I’m working on with Johannes Stroebel and several other co-authors at NYU, we look at the trading behavior of mutual fund managers following heat waves that occur near where the funds are located, and compare it to the behavior of managers who weren’t impacted by that heat event. We look at heat waves specifically because it’s been shown that following periods of extraordinary temperatures, people start getting worried about climate change. We then use this information to build our hedging portfolio.

The intuition behind our approach (which we label “quantity-based approach”) is very simple. Some investors are affected by a local shock, which makes them see climate risk as more serious or likely. They then buy some stocks and sell other stocks. Because the shock is local, there aren’t enough people reacting to affect the prices of the stocks, but we can learn from the actual trading behavior to predict how they will behave when a global shock occurs. In that event, we expect many fund managers buying and selling the same stocks, with an effect on prices as well. Therefore, a portfolio built based on local response information should appreciate in value when a global climate shock hits (and therefore it works as a hedge to climate risks).

We find that you can indeed build a hedging portfolio using this approach, and it works well in the data. We use data from 2010 to 2014 to estimate the responses to the local shocks, and we evaluated the ability of the portfolio to hedge global climate shocks using data from 2014 to 2019. We show that this approach works significantly better at hedging climate risks than all other approaches that people have tried in the past. It does better than our previous model that used dynamic hedging of news. And surprisingly, it also does much better than an approach that is very widely used in the investment community, which we label the “narrative” approach. This approach builds a portfolio around a narrative about which stocks will appreciate or depreciate in the event of a climate shock, without using data on historical behavior—e.g., “I’m going to buy an ETF that contains clean energy companies and I’m going to sell an ETF that contains traditional energy companies.”

The narrative approach might miss some unexpected behavior of particular stocks. For example, we don’t know why exactly, but traditional energy companies have not been doing that badly when there has been negative climate news, so they haven’t been a good hedge, contrary to standard intuition. It may be that while their existing businesses may suffer, they also may be sources of clean energy innovation, so in a sense they are internally hedged.

Whatever the reason, our results show that common assumptions about which companies and industries will go up and which will go down may be mistaken. Our statistical approach helps address this issue by learning from market reaction (that is, from the wisdom of the crowd).

Q: What is your next round of research?

I’m continuing to tackle hedging portfolios and how to think about hedging climate risk broadly.

Also, I’m collaborating on research trying to understand the energy sector because it’s really at the core of the climate change debate. If we can define a clear transition to green sources of energy, that would solve a lot of the problem.

And finally, I’m exploring the best ways for financial markets to help the transition. Is it through the cost of capital? Is it investor activism pressuring company management? Or are there other ways in which financial markets can help?