A growing number of financial institutions, from BlackRock to the Bank of England, have reached the conclusion that markets are not accurately assessing climate change-related risks. European Central Bank President Christine Lagarde recently warned that central bankers “will have to ask themselves” if they are “taking excessive risk by simply trusting mechanisms that have not priced in the massive risk that is out there.”[1] According to one survey, 93 percent of institutional investors agree with her that climate risk “has yet to be priced in by all the key financial markets globally.”[2]
Yet while the consensus (and evidence) grows that assets are mispriced, there has been less attention paid to diagnosing why that might be; what are these faulty “mechanisms” that Lagarde says are not to be trusted?[3] In my new article, Market Myopia’s Climate Bubble, I seek to explain how this mispricing can exist, disputing arguments that climate risks are “already reflected in existing stock prices.”[4] I describe six drivers of mispricing.
First, shareholders and analysts currently lack the fine-grained asset level data they need in order to make climate-risk assessments. Where corporate operations are located, the origins and routes of their supply chains, the sources and quantities of inputs like water and energy – this is the type of information needed to assess climate risk exposure but not currently disclosed in financial reports. Often, the information that is voluntarily disclosed aggregates data at too high a level, is given at widely varying time-scales that make comparison difficult, and fails to differentiate well between exposure and liability.
Second, market actors continue to rely on risk assessment methods that are outdated in a climate-changed world.[5] They may employ strategies that expose them to model risk, such as relying on unrepresentative historical records to project future exposure. And traditional means of risk assessment may ignore latent risks: The entire capital stock of corporate America was built using engineering specifications designed to endure certain temperature and weather extremes that may be regularly exceeded under a climate-changed world. A facility that was built to withstand a “100-year flood” may now have a much higher likelihood of failure. Additionally, corporate managers may continue to rely on outdated methods of risk assessment that may suffer from a duration mismatch. Insurance premiums are reassessed annually and so could spike suddenly to reflect unaccounted-for climate risk; yet they are nevertheless relied upon as a proxy for the cost of risk for investments with expected returns over many years.
Third, corporate managers, with an eye toward maintaining a high share price, have little incentive to discover and disclose information that might reveal their company’s stock price is overvalued.[6] Equity-based compensation and firm-specific executive remuneration metrics may encourage managers to focus on the short-term and neglect to prepare their companies for longer term climate resilience.[7]
Fourth, many physical climate risks will occur within the relevant horizon for valuing securities but outside of conventional risk assessment horizons for investors that trade in the market. The investors with the longest investment horizons largely follow an indexing or quasi-indexing strategy – passively holding their funds instead of spending resources to research firm-specific fundamental values. While investors continue to shift their money into funds with an environmental, social, and governance (ESG) focus, perhaps suggesting an awareness of climate risks, there is insufficient scrutiny of index providers and their climate-related methodologies.[8]
Fifth, decades-long disinformation campaigns have intentionally confused public understanding of the cause and effects of climate change. Lessons from behavioral finance tell us that investors and corporate managers can be slow to integrate new information, can be irrationally myopic, and can overvalue short-term gains and undervalue longer-term losses – all of which, in the context of climate change, serves to maintain apathy regarding mitigation investment and long-term risk avoidance.[9]
Sixth and finally, shareholders concerned about climate risk have begun to press for voluntary disclosure from companies, but their efforts face opposition from corporate management both directly and through industry influence on government regulators. Under the Trump Administration, several agencies took actions to limit shareholder oversight of climate risks, including blocking requests for climate disclosure and preventing investors from integrating climate risks into their market decisions.[10]
The widespread under-assessment of climate risk may lead to two undesirable economy-wide harms: 1) systemic risk to the financial system and 2) the physical damages stemming from climate change itself as mispriced equity leads to misallocation of investment resources. If investors fail to demand risk assessment from companies, managers may be left unpunished by the market when they build homes and hotels in hurricane-prone regions too close to the shore or build bridges to withstand a “100-year-flood” based on a grossly unrepresentative historical record. This mis-investment imposes costs, not just on the company and the investor, but on the communities harmed by collapsing bridges and hotel evacuees.
Addressing climate-risk neglect will require an array of actions, from regulators and investors alike. Signals from the Biden Administration suggest a mandatory climate-risk disclosure regime may be forthcoming in the United States.[11] My article supports this agenda and provides some high-level guidance on how to design regulation to address the drivers of climate risk mispricing. Any mandatory climate risk disclosure regime has to meet climate science where it is. Regulators must pay particular attention to the spatial and temporal scales of requested disclosures and ensure they are both scientifically feasible and tailored to industry-specific needs.[12] In particular, an overemphasis on false precision provided by complicated models might obscure the usefulness of other methods of risk assessment and communication.[13] This fact should inform how the SEC decides to structure climate-risk disclosure compliance, including balancing the pros and cons of principles-based versus line-item disclosures. In crafting disclosure regulation, the SEC should seek out climate-related expertise through interagency working groups, advisory boards, and staff hiring.[14]
No amount of disclosure, however, can protect the market from climate change. The only path toward financial stability requires halting emissions. Direct regulation will be required to address not just mitigation deficits, but physical risks and adaptation deficits as well. Beyond the “market failure” of emissions externalities, there is a limit to what increased disclosure can facilitate in the face of systemic risks; climate risks remain unhedgeable even with increased information.
ENDNOTES
[1] Carolynn Look, Lagarde Says ECB Needs to Question Market Neutrality on Climate, Bloomberg (Oct. 14, 2020), https://www.bloomberg.com/news/articles/2020-10-14/lagarde-says-ecb-needs-to-question-market-neutrality-on-climate.
[2] Climate Change and Artificial Intelligence Seen as Risks to Investment Asset Allocation, Finds New Report by BNY Mellon Investment, Bloomberg, (Sept. 16, 2019), https://www.bloomberg.com/press-releases/2019-09-16/climate-change-and-artificial-intelligence-seen-as-risks-to-investment-asset-allocation-finds-new-report-by-bny-mellon-investm.
[3] With the noted exception of Jakob Thomä & Hughes Chenet, Transition Risks and Market Failure: A Theoretical Discourse on Why Financial Models and Economic Agents may Misprice Risk Related to the Transition to a Low-Carbon Economy, 7 J. Sus. Fin. & Investment 82 (2017).
[4] Paul Brest, Ronald J. Gilson & Mark A. Wolfson, How Investors Can (and Can’t) Create Social Value, 44 J. Corp. L. 205, 227 (2019).
[5] Cf. Ronald Gilson & Reinier Kraakman, Market Efficiency after the Financial Crisis: It’s Still a Matter of Information Costs, 100 Va . L. Rev. 313, 343-44 (2014) (discussing how valuation models employed by banks and ratings agencies failed because they relied on historical housing price data to model future risk and ignored warnings of high unaccounted-for correlations between assets).
[6] See, e.g., John Armour, Jeffrey Gordon & Geeyoung Min, Taking Compliance Seriously, 37 Yale J. Reg. 1, 26-31 (2020) (arguing that stock-based, including options-based, executive compensation models incentivize corporate managers to neglect risk management programs, to the detriment of the long-term value of the stock).
[7] Cf. Michael Jensen, Agency Costs of Overvalued Equity, 34 Fin. Manag. 5, 7 (2005).
[8] See, e.g., Joe Rennison & Billy Nauman, Vanguard ‘Green’ Fund Invests in Oil and Gas-Related Stocks, Fin. Times (July 10, 2019); Adriana Robertson, Passive in Name Only: Delegated Management and “Index” Investing, 36 Yale J. on Reg. 795, 848 (2019).
[9] See, e.g., Stephen J. Choi & A.C. Pritchard, Behavioral Economics and the SEC, 56 Stanford L. Rev. 8 (2003); Amos Tversky & Daniel Kahneman, The Framing of Decisions and the Psychology of Choice 211 (4481) Science 453-458 (1981).
[10] See e.g., Fair Access to Financial Services, 85 Fed. Reg. 75,261 (Nov. 25, 2020) (to be codified at 12 C.F.R. pt. 55).
[11] See e.g., Emily Glazer, Companies Brace Themselves for New ESG Regulations Under Biden, Wall St. J. (Jan. 18, 2021) https://www.wsj.com/articles/companies-brace-themselves-for-new-esg-regulations-under-biden-11610719200?mod=searchresults_pos3&page=1.
[12] See e.g., Tanya Fielder et al., Business Risk and the Emergence of Climate Analytics, Nature Climate Change (2021). The Sustainability Accounting Standards Board creates voluntary industry-specific standards, with quantitative metrics for 77 different sectors. Standards Overview, Sustainability Accounting Standards Bd.
[13] See e.g., Fielder et al., supra note X.
[14] See Madison Condon, Sarah Ladin, Jack Lienke, Michael Panfil, & Alexander Song, Mandating Disclosure of Climate-Related Financial Risks, Institute for Policy Integrity and Environmental Defense Fund (2021).
This post comes to us from Professor Madison Condon at Boston University School of Law. It is based on her recent article, “Market Myopia’s Climate Bubble,” available here.