Capital Markets, Risk Sharing and Climate Change

  

Miami Beach

From BusinessInsider.com

Atlantic City

“right now, if you are worried about climate change, you cannot buy insurance to protect yourself.” 

Tweet from Stefano Giglio, Yale finance professor 

Right now, our stock markets are humming along, reacting to big issues – like pandemic control and supply chain deficits – and smaller issues like Federal Reserve rate changes. But what the markets are really bad at assessing is the expected damage and cost of climate change. As unseasonal and massive tornados threaten to become the new normal, wildfires take out millions of acres every year, hurricanes render major cities helpless and devastated, water shortages in other areas wreak endless drought if not desertification and noting that millions of acres of high value coastal lands – including huge cities like Miami/Miami Beach, Atlantic City and NYC/Manhattan – are very likely to become undersea relics of an indifferent past, the capital markets just plain do not have a guiding strategy to deal with the trillions and trillions of dollars of loss that climate change will likely impose (and continue to impose) in the foreseeable future.

Sure, it might be difficult to get a 30-year mortgage anymore in parts of coastal Florida. And yes, many California farmers cannot get enough water to grow their traditional crops, sending food prices even higher. We’re not sure if Las Vegas is a viable city as water resources dry up and blow away, but folks are still building casinos and housing developments there. Mid-West plains, farther east than we have seen in the past, are getting rolling cold-weather tornados – a function of the newly trending hotter moist air colliding with winter cold fronds – that take out entire towns and businesses. Heat waves are hotter than ever, killing more people with the passing of every year. So what? How can the capital markets price this into share values?

There are idiotic politicians who decry the very notion of out-of-control climate change, creating a confusing and erroneous belief in the minds of many that this nothing to worry about. At worst, just kick the can down the road. But it’s actually a climate emergency now. Accepting the very necessary preventative and reversing steps necessary to halt the destruction give way to patchwork bandages, pledges of something relevant decades in the future and out-and-out denial reflected in an unwillingness to abandon industries and practices as “inconvenient” or “disruptive” to American business. But what will their response be to a wiping out of the lower third of Manhattan, the disappearance of Miami and the massive impoverishment of so many Americans whose homes and livelihoods will vaporize as Mother Nature continues to escalate massive climate change consequences.

If government cannot adequately accommodate the necessities of climate change, exactly what will or can the capital markets do to mitigate or at least reflect these horrific, very obvious and potentially permanent climate realities? Nature truly does not care about an inconvenience to humanity or that politicians and their blind sheep don’t believe (want?) in the coming harm. The laws of physics cannot be reversed by a plunging stock market. That market seems to fly up and down with relatively mouse-like economic changes but seems indifferent to the rampaging herd of climate change dinosaurs galloping in our midst. 

Yale finance professor Stefano Giglio, who is quoted above and was interviewed in the December 14th Yale Insights, addresses this anomaly: “I cannot tell you whether [climate change is] 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…

“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…

“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…

“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.” So, convincing enough people well beyond the traders themselves and generating more reliable quantative realities that are as acceptable to the financial community as the harsh facts of climate urgency has been accepted by 99% of the relevant scientific community seem key. 

But no market force strong enough to make a difference has even begun to step forward based on those necessities. We even seem to be going the other way, as Giglio and his fellow researchers have discovered: “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  [environmental, social and governance conscious] 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…

“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.” Despite the optimistic final note, it is necessary to understand that governmental delays in implementing corrective measures to stop and reverse climate change are profoundly linked to the needs and perceptions of the capital markets. Upgrading and educating those markets is mission critical!

I’m Peter Dekom, and most Americans simply do not comprehend the negative power of inadequate or wrongheaded perceptions of the capital markets on the very existential threats posed by our climate emergency.