ESG Club interview – EDHEC-Risk Climate Impact Institute
premium – then it should make sure that its risk-budget, for example, value at risk utilisation in ‘normal times’, is well below the limit. If not, the institution will see itself forced to liquidate the risky posi- tions at the first sign of turmoil.
Therefore, are green assets hedging against risk or adding to it? We have few empirical answers for this ‘trillion-dollar question’ and the empirical studies conducted so far have given con- tradictory answers. This is why state-of- the-art theoretical models can give inves- tors some help. Currently, a robust finding of these mod- els is that the largest climate damages materialise if the global economy is firing on all cylinders: because of the link from economic expansion to emissions to con- centrations to temperature increase to damages. So, an asset that paid well in states of high climate damages, let’s call it ‘green’, would pay well when equities pay well and would, therefore, attract a positive risk premium.
One important observation: investors must distinguish between risk premia ex-ante and ex-post. If a security is per- ceived to perform badly in poor states of the world, its lower price already reflects this information, and the investor, therefore, enjoys the positive risk pre- mium today. However,
The sweet spot for physical climate risk premia is long, but not extremely long, dated assets.
dated, as it is long-dated cashflows that are more likely to be affected by physical climate risk. Somewhat surprisingly, extremely long- dated assets – there are some treasury bonds with 100-year maturity – are not affected as much because, sooner or later, we expect the climate problem to be brought under control. So, the sweet spot for physical climate risk premia is long, but not extremely long, dated assets.
So how does the climate risk premium depend on what you describe as future abatement policies?
if investors realise tomorrow that the same security pays badly when everybody feels poor, then the downward price adjustment will only occur tomor- row, and today’s holders will post a loss. There are reasons to believe that current valuations reflect climate risk partially at best: investors beware.
Can you explain the structure of the cli- mate risk premium? Are long or short-dat- ed assets more strongly affected? As far as physical risk is concerned, the assets that could attract the highest risk premium – positive or negative – are long-
28 | portfolio institutional | July-August 2023 | Issue 125
The climate risk premium depends cru- cially on future abatement policies. If we abate little, then climate damages are going to be much larger, and the climate sensitivity of cashflows – the ‘climate beta’ – to climate outcomes will also be corre- spondingly larger.
An estimate of the magnitude of the cli- mate risk premium is, therefore, a joint estimate of whether the largest climate damages
will materialise when the
economy is strong or weak and of the aggressiveness of our climate policies. What I would add here is that the likeli- hood of abating too little is much, much higher than the likelihood of abating too
much – so the risk premium has a simi- larly skewed distribution.
How robust then are the results to climate uncertainties and model limitations? There is huge model uncertainty, and all projections should be associated
with
large error bars, which are too frequently forgotten. Having said this, we do have valuable information, and the defeatist view that the problem is so complex that models are of no use is not constructive. The key trick is to use all the information we have while keeping in mind what we do not know. We should remember that knowing what we do not know is useful in itself. Having said this, one of the most robust findings of climate/economy models is that we can expect the largest climate damages in strong states of the global economy, especially if robust growth occurs in yet-to-develop countries. All models concur that the joint effects of demographic and economic growth of poor countries will have a profound effect on climate outcomes. What the models cannot tell us is whether this growth – if it happens – will be fuelled by renewables or fossil fuels.
You have mentioned that the market may be asleep at the wheel on climate change: what do you mean by that?
If we do little to tackle climate change and keep on kicking the climate ball into the high grass, temperature increases can take us to levels never seen by Homo Sapiens. Just 3-degrees would be unchar- tered territory. If, instead, we get our act together and act decisively, the whole economy will have to be rewired – pro- foundly and in a short time.
Either outcome should have a marked effect on valuations, either in the aggre- gate or at the sectoral level. Yet, the sig- nature left in asset prices by these events is
barely detectable. This makes me think that a significant risk re-pricing may be overdue.
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