Equity investors are not pricing in physical risks from climate change, the International Monetary Fund (IMF) has indicated in a new report calling for mandatory climate risk disclosure.
Stock prices have so far not reflected projected future climate risk, and they have only modestly reacted to large climatic disasters, according to the findings of the report, Global Financial Stability Report on Climate Change: Physical Risk and Equity Prices.
The publication raises potential implications for financial stability, warning that “a sudden shift in investors’ perception of this future risk could lead to a drop in asset values, generating a ripple effect on investor portfolios and financial institutions’ balance sheets”.
It first looks at whether aggregate equity prices, bank equity prices and insurance equity prices have dropped in line with large climatic events in the past – and finds that on average there has been only a modest response of stock prices to disasters.
Stock prices were down an average of 1% from 21 days before a disaster to 40 days after, according to the findings.
In the case of Hurricane Katrina – the biggest disaster in the sample in absolute constant US dollar terms – only a modest stock market reaction was triggered, with “no discernible drop” in the US stock market index.
The results vary across disasters, however; the 2011 floods in Thailand, which resulted in the largest damage in the sample relative to the size of the economy, resulted in a drop in the Thai stock market index of more than 8% soon after the disaster and a drop of about 30% after 40 trading days.
It suggests that mandatory climate disclosure could be based on globally-agreed principles in the short term, and that climate disclosure standards could be incorporated into financial statements compliant with International Financial Reporting Standards in the long term.
On pricing future physical risk, the report looks at whether aggregate equity valuations in 2019 were correlated with economy-specific climate hazard projections, and finds “no evidence” of this being the case.
An alternative approach, focused on a greater projected increase in hazard risk combined with either a sensitivity to climate change or a lower capacity to adapt to climate change found that neither combination were associated with lower valuations.
The pricing of other asset classes, meanwhile, shows some evidence of factoring in physical risk, the report says, citing the higher costs of issuing municipal bonds faced by US counties expected to be worst affected by rising sea levels.
The report notes that equity investors “face a daunting informational challenge”, and explains that it uses cross-country econometric analysis and proxies for future physical risk changes in its analysis “in the absence of granular firm-level information and time-varying measures of future risk”.
“Even if investors had the ability to correctly price the change in physical risk, the time horizon over which this change is likely to unfold may be longer than the investment horizon of most investors, including institutional investors.”
Investors should be paying more attention to rising temperatures caused by climate change, too, the report says, suggesting they are not making use of “a climate variable that…is not predicted or model-dependent, but can actually be observed at high frequency”.
According to the report, companies that are sensitive to shifts in temperature can be shown to underperform in ways that aren’t captured by the traditional “market efficiencies” thinking of most investors.
It takes a sample of 27 economies over 1998-2017 and finds a “temperature-related pricing anomaly” in more than half. In 10 of the economies, a portfolio composed of the top 20% of stocks most sensitive to temperature, underperformed by at least 0.5% per month, on average, over the sample period.
“The presence of such a pricing anomaly indicates that equity investors in most economies have not paid enough attention to climate variables and suggests that they may not be paying sufficient attention to climate change risk either,” the report says.
The report recommends developing global mandatory disclosures on material climate change risks as “an important step to sustain financial stability”.
It suggests that mandatory climate disclosure could be based on globally-agreed principles in the short term, and that climate disclosure standards could be incorporated into financial statements compliant with International Financial Reporting Standards in the long term.
The report’s findings also indicate that insurance penetration and sovereign financial strength can lessen the impact of climatic disasters on equity prices, including of the financial sector, and it suggests that policymakers consider mandating coverage for climatic disaster risks and subsidising climatic disaster insurance.
When Kristalina Georgieva became Managing Director of the IMF last year, she said the organisation was “gearing up rapidly” to integrate climate and environmental risks into its economic analyses, and more work on climate risk is in the pipeline. Further issues of the Global Financial Stability Report are expected to focus on managing the low-carbon transition to avoid abrupt and unanticipated repricing of portfolios and economic dislocation.
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