Unclear whether markets rationally price climate risk – Norges-backed review

Giant investor sponsors academic review and workshop

A new review of current academic literature sponsored by Norges Bank Investment Management (NBIM) has found there is not enough evidence as yet to tell whether financial markets are correctly pricing climate risk.

NBIM, the arm of the Norwegian central bank which runs the country’s giant sovereign fund that has come under scrutiny for its fossil fuel investments, had asked three Norwegian higher education institutions to collaborate on an academic workshop to evaluate current thinking and theory on climate change in financial economics.

This led to an event featuring leading scholars from finance, macroeconomics, environmental and resource economics that was held on January 20 this year.

Also part of the project was a review of the literature by University of Oslo PhD candidate Ingrid Hjort. “Throughout this study several gaps and missing studies have been discovered,” she writes, noting that few studies try to identify whether financial markets are mispricing the climate risk by testing this empirically.

“The results from these few studies are not enough to draw an overall conclusion whether financial markets optimally and rationally price the climate risk,” she notes. It was “unclear whether the market reactions are consistent with rational market valuation of the climate risk”.

The 94-page review, which does not necessarily reflect Norges’ own views, does not claim to be exhaustive but does reflect that there are few studies combining climate economics and finance. For example, Hjort could only find two studies that address whether climate risk is hedgeable: those by the Cambridge Institute for Sustainability Leadership [CISL] in 2015 and Andersson et al. (2016) – and even they “have different views” on the topic.The Andersson referred to is Mats Andersson, CEO of Swedish state fund AP4, whose ‘Hedging climate risk’ with Columbia University’s Patrick Bolton and Amundi’s Frédéric Samama is due for publication in the Financial Analysts Journal.
Hjort prioritized more recent papers with clearly academic purpose and she also looked at unpublished papers which were “likely to become important pieces in the published literature”. Her ‘Potential climate Risks in Financial Markets: A Literature Overview’ is available here.

She also prepared the workshop review. One speaker at the session was Columbia’s Bolton, whose presentation looked at hedging climate risk with indices. The review says: “Based on back-testing from 2012 to November 2014, and on actual market performance since the introduction of the MSCI Europe Low Carbon Leaders Index in November 2014, the design works, meaning that the decarbonized index does have a low tracking error. What is more, it has so far outperformed the benchmark index.”

It adds: “It gives substantial carbon reduction, low tracking error and superior returns. At this moment the market is not pricing carbon risks fast enough creating a window of opportunity for superior returns.”

And the workshop report cites Rick van der Ploeg of Oxford University as saying that oil-rich countries with a Sovereign Wealth Fund (SWF) need to think of decarbonization strategies: “They should divest, or develop better dynamic and transparent hedging strategies against the risk of a dramatic and prolonged fall in oil prices.”