Climate risks are greatly impacting global equity valuations, especially in areas with limited climate action, a study by EDHEC-Risk Climate Impact Institute has revealed.
The study – How Does Climate Risk Affect Global Equity Valuations? A Novel Approach – debunks the notion that the value of global equities is immune to climate changes. It examines the impact of climate change-induced transition costs and physical damages on global equity valuations. This was completed by pricing equity as the sum of discounted claims on consumption, across climate and economic scenarios consistent with different greenhouse gas emissions courses.
The study found there are two key contributors to changes in equity evaluations. First, the uncertainty of climate and economic outcomes, and second, the dependence on discounting. The magnitude of losses depends on the aggressiveness of emission abatement policy; the presence of tipping points; and central banks’ willingness and ability to lower rates in states of economic distress.
It also found that a “robust” abatement policy, ideally consistent with the 2-degree Paris Agreement target, can keep losses below 10%. On the other hand, the correction to global equity valuations could be as large as 40% if abatement remains at historic rates.
In terms of tipping points, the study explained they exacerbate equity evaluation shocks, but are not required for substantial equity losses to be incurred.
It added that equity valuations can be severely impacted via a combination of policies and physical outcomes. There is considerably more downside than upside risk, the study found, with more than 40% of global equity value at risk unless decarbonisation efforts accelerate. It found that losses could exceed 50% with near-climate tipping points.
Frédéric Ducoulombier, director of EDHEC-Risk Climate Impact Institute, said: “The research team led by Professor Rebonato has upgraded mainstream integrated assessment models to incorporate the progress of climate science and make them fit for financial applications.
“By modelling the considerable uncertainty in the physical and economical dimensions of climate change and linking it to top-down equity valuation, this study debunks the notion that the value of financial assets may be immune to climate changes and provides additional support for bold climate action.”
Professor Ricardo Rebonato, scientific director of EDHEC-Risk Climate Impact Institute, added: “These results underline the importance of uncertainty and state-dependent discounting for climate-aware equity valuation.
“Our approach shows that it is possible and fruitful to integrate climate risks into financial analysis and we will be working further to develop theoretically solid and practically implementable tools for climate-aware investment management.”
