Sunday Brunch: how investors think about climate risk
Sustainability, Strategy & Finance

Sunday Brunch: how investors think about climate risk

How finance people think about climate risk really matters. If they see the risk as real, they will act. If they don't, the movement of private finance into climate related solutions will be weakened.

How finance people think about climate risk really matters. If they see the risk as real, they will act. If they don't, the movement of private finance into climate related solutions will be weakened.

You may be asking, how can finance people not see that climate risk matters? After all the science is really clear and well accepted.

The answer comes down to the different way that finance people view the world. Their first question isn't 'is climate risk important' - it's 'is climate risk already reflected in prices of shares, bonds and other investments'.

Let's dig down into what this means, and why it's important.

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Mental models in financial markets

Yes, not the most catchy title, so lets try another one

'How can investors believe climate risk is very real, and still decide not to invest?'.

No, they are not stupid, or uncaring, or even greedy (well, a few of them might be, but not the vast majority). They just view the world from a different perspective, one that we need to understand if we are to get private sector finance to flow at scale into climate related investments.

Before I start, let's introduce the experts. Bauer, Godker, Smeets & Zimmerman. If you work in my industry these are names you will recognise. And they recently published a really interesting (and useful) report for the IZA.

Mental Models in Financial Markets: How Do Experts Reason about the Pricing of Climate Risk?
We investigate financial experts’ beliefs about climate risk pricing and analyze how those beliefs influence stock return expectations. In a comprehen…

I really suggest that you read their paper. It's not written for a non academic/non financial audience, but it's worth the work. Before talking about their study, a bit of context.

Finance people think about shares and bonds (and other financial instruments) differently from what you may think.

When faced with an investment choice they ask themselves, 'is all the available information about this company known and reflected in the share price'. Because if it is, it's what is known as fairly priced. And if it's fairly priced I cannot expect to make a decent return by buying it (investing in it).

Investing is about putting a price on future events, risks and opportunities. We might think it should be something else, but that is how the system works.

It's worth thinking about this for a minute. Fairly priced shares do not give you the financial return you are seeking. If it's cheap (under valued) then you buy it, and if it's too expensive (over valued) you sell, or short it. Markets are really good (most of the time) at absorbing all of the available information and correctly pricing the value of a share, at that point in time.

There is a reason why they are called financial markets - they are where investors trade with one another, based on different views about the future, and how much they are already reflected in share prices.

On climate, this means that if investors believe that the market is not correctly anticipating, and most importantly, pricing in the risks, they will invest. If they think the outcomes are already factored in, they will not.

We talked a bit about this in a recent blog, looking at how the market is probably mis-pricing climate change harm risk.

Sunday Brunch: is failure on climate change really financially harmless ?
We talk a lot about climate models and how GHG emissions impact temperature, but not so much about climate damage function models. And yet this second set of models have a massive impact on financial decision making.

At this point I am guessing that many of you are going - hang on a minute.

The science of climate change is well understood and accepted. And we know with a reasonable degree of certainty that the impacts on our society are going to be damaging, probably very damaging. So how can investors not see this, how can they think that the market is correctly pricing future risk?

Which is where the research of Bauer, Godker, Smeets & Zimmerman is so interesting.

What did they find?

I apologise to the authors for grossly simplifying their analysis - hopefully I have got it broadly right.

First, many financial experts share the view that climate risks are "not sufficiently reflected in share prices". So as a group investors understand that climate risk is not 'priced in'.

Although a big group (about 1/3) still think that climate risks are not very important, or not at all important, in terms of their impact on share prices. But then if you read the press you will know that already.

Second, investors have different mental models of how climate risk will become real. Nearly half think that data challenges are the limitation - once we have better data we can better judge what the impact might be, and how we should respond. This argument is getting harder to sustain, as set out in a recent report from the Institute and Faculty of Actuaries (that very conservative and sensible body).

Emperor’s New Climate Scenarios – a warning for financial services | Institute and Faculty of Actuaries

But, interestingly a slightly larger group think that the issue is what other investors think.

What does this second point mean in practice? Let's go back to the idea of share prices being set by markets - the clash of ideas about what the future will look like. If you believe that climate risk is real, and that it is being under-priced in the market BUT you also think most investors disagree with you, then you will probably hold back. The market price is set by the majority, not by you being right.

All investors know the famous quote (attributed to John Maynard Keynes, but probably said by Gary Shilling) "markets can remain irrational a lot longer than you and I remain solvent". This gets interpreted as don't bet against the market.

Those of us of a certain age remember Tony Dye, known as Dr Doom for his negative views on the internet bubble. He refused to buy these bubble stocks and as a result his funds under-performed. He lost his job in 2000 just before the market crash, which many argue vindicated his cautious stance.

And the last mental model is about government policy and regulation. If you think that climate risk is real, but that governments will not act, then investing to hit 1.5 C or <2 C targets could be a losing bet. This is at the crux of the arguments put forward by respected academics such as Tom Gosling.

Trouble ahead for GFANZ — Tom Gosling
Asset managers need to figure out how to align membership of GFANZ with their fiduciary duty to clients, and fast.

Pulling this together.

Most investors accept that climate risk is real, and that the current share prices are not fully pricing it in. But they also think that we don't have enough data to accurately judge the impact, or that too many other investors think differently for share prices to move, or that governments will fail to act.

What might change these views? More analysis such as the Institute and Faculty of Actuaries report we referred to above should bring some good financially focused data into the debate. And the more investors who change their minds, the less they will worry about what other investors think. Plus governments could act ! And finally, the impacts could become so obvious that even the most cautious will change their views.

This is a hurdle we need to get over. If investors are unwilling to act because of worries about under performing and losing their jobs (see Dr Doom above), then the private finance flows we need will not happen. One under-explored lever is the willingness of what are known as asset owners, so pension funds, insurance companies, and you & I, to say to those that invest our money (asset managers) ....

'climate risk is real, and we want you to invest in solving the challenges, so we are willing to accept lower financial returns in the short term in the belief that its better in the long run'.

One last thought. The survey also found that political preferences play a part in this, but only in the US ! But no surprise there.

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