EDHEC-Risk Climate Impact Institute – ESG Club interview
not like these ‘fair-weather friends’ and, therefore, pay less for them – lower price, higher expected return. Conversely, US treasuries and bonds attracted a negative risk premium up to the Covid crisis because they were per- ceived as providing a hedge to equity wob- bles: the ‘Greenspan put’ – that is, to act as insurance by performing well when the rest of the portfolio was doing poorly. So, the same expected cashflows can be val- ued differently if they materialise in good or bad states of the economy.
important, role in controlling climate change. Investors can play a significant part in this respect. However, every scientist and the Intergov- ernmental Panel on Climate Change agree that all paths to a manageable level of warming by the end of the century require substantial carbon removal. Un- fortunately, we have very few practical car- bon removal options, such as afforesta- tion and reforestation, that can be deployed in scale now. Even the ones that we do have are no panacea, for instance, because of competition for land from afforestation.
Other removal technologies are expensive and require a lot of energy that must be provided by renewables unless we want to use up our carbon budget. Unfortunately, talking about non-abate- ment routes to climate control is unpopu- lar because of the perceived risk of moral hazard. However, if we fail to devote re- sources to direct carbon removal, the tem- perature outcome by the end of the centu- ry will be well outside the Paris targets. So, we must indeed think of reaching net- zero soon – the sooner, the better – but we
must start to think seriously about net- negative as well. All ‘experts’ agree on this point, but the importance of substantial carbon removal has rarely been on the radar screen of politicians, and, arguably, of investors.
The same investors should also realise that if the transformations of the economy associated with large carbon removal do not take place, then we should brace our- selves for much higher temperature outcomes. Big transformational changes are afoot whether we act decisively or we don’t. The net-zero target via abatement, useful as it is, can create complacency: it is a neces- sary first step but not the be-all-and-end- all of climate control.
You have studied the climate risk premium in detail: what it is and why should inves- tors care?
All risk premia depend on whether the security in question pays well or badly when we feel rich or poor. Equities attract a positive risk premium because an equi- ty portfolio pays badly when the whole economy is in the doldrums. Investors do
Investors should care a lot about this because the risk premium can be a sub- stantial part of the expected return from an asset. Indeed, part of the current high treasury yields in the US and the UK are due not just to inflation expectations but also to the fact that the negative risk pre- mium has evaporated. This has happened because investors are no longer willing to pay an ‘insurance premium’ because the insurance policy doesn’t seem to work anymore.
When it comes to hedging climate risk, when is it possible and when should inves- tors do it?
If an investor has identified a robust hedg- ing instrument, and wants to be insulated with respect to that risk, the hedge should be put in place as soon as the risk is iden- tified. In some cases, deploying the insur- ance strategy continuously is too expen- sive: as in the case of out-of-the-money equity puts. However, it is better to buy more out-of- the-money protection than to try to time the entry and exit points for the hedging strategy. Having said this, recognising that a portfolio is exposed to a risk factor, such as climate, doesn’t automatically mean that the risk should be hedged away – it all depends on how handsomely the risk is rewarded and on the ‘staying power,’ such as internal or limit con- straints, of the institution.
If an institution decides that it wants to ‘ride the risk’ – and extract the risk
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