- Climate risk is a concern for many investors.
And for good reason, there has been an unprecedented surge
in economic development over the last 200 years
largely driven by the power of fossil fuels.
We've correspondingly seen rising levels of carbon dioxide
and other greenhouse gases in our atmosphere
and an increase in the global means surface temperature.
Further temperature increases are expected
and their social and economic effects could be substantial.
From the perspective of investors,
the concern is that climate change
may adversely affect asset prices.
For example, owning companies whose business model relies
on fossil fuels may not seem like such a good idea
if the world is moving toward a fossil fuel-free future.
I'm Ben Felix, Portfolio Manager at PWL Capital.
In this episode of Common Sense Investing,
I'm going to tell you how climate change
should inform your investment decisions.
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A changing climate creates physical risk
potentially affecting businesses, communities
and the economy.
Changing weather patterns
and previously habitable areas becoming uninhabitable
due to temperature or flooding
or examples of the physical risks of climate change.
The transitional risk of climate change
arises from the response of consumers and governments
to climate change.
The possibility that consumers will demand
a lower carbon impact from products and services,
and that governments will introduce regulations
or taxes designed to reduce emissions,
creates meaningful uncertainty for businesses.
Asset prices reflect expectations
about future cash flows
and a discount rate reflecting the expected return.
Physical and transitional climate change risks
are likely to reduce expected cash flows
and increase the discount rate for affected businesses
putting downward pressure on their valuations.
Another channel separate from risk
that may affect the discount rate
is the tastes of investors as described
in Fama and French's 2007 paper
"Disagreement, Tastes, and Asset Prices."
If enough investors avoid allocating to a type of asset
due to a preference that is unrelated
to risk and expected return,
the price of that asset decreases,
increasing its expected returns.
In a 2020 theoretical paper titled
"Sustainable Investing in Equilibrium"
Lubo Pastor applied this concept specifically
to investors preference for owning green assets
where green refers to firms
that generate positive externalities for society
while brown firms generate negative externalities.
In Pastor's model, investors prefer to own green assets
which leads them to accept a lower expected return.
The model also implies that green assets
have lower expected returns
because they hedge climate risk.
If there's an unexpected worsening of the climate,
consumers may exhibit greater demands
for the goods and services of green providers,
government regulations could push
these demands even further
and investors taste for green assets may get stronger
decreasing the cost of capital for green firms.
In all cases, green firms benefit
from an unexpectedly worsening climate
making them safer to own with respect to climate risk.
In theory, green assets have lower expected returns
because lots of investors feel good
about owning them and because they hedge climate risk.
This theoretical point raises
an important empirical question for investors,
is climate risk priced in the way
that Pastor's model suggests?
If it is priced, then green assets should have higher prices
and lower expected returns than brown assets.
If the climate deteriorates as expected, not worse
green assets should realize lower returns than brown assets
or else equal.
If the climate deteriorates more than expected,
then the hedging property of assets becomes valuable.
Over awaiting green assets with the hope of profiting
from their hedging property would be an active bet
against market prices.
Like most predictive actions in the stock market
the payoff would be questionable at best.
Financial markets are the best information
processing machine that humans have ever created.
They align in for investors to be the first
to bring new information that may affect asset prices
to the market.
To answer this empirical question, there is a large
and growing literature on the relationship
between asset prices and climate risk.
Regarding the pricing of physical climate risk,
a 2019 paper titled
"Market Expectations About Climate Change"
by Wolfram Schlenker and Charles Taylor
examines weather futures contracts traded
on the Chicago Mercantile Exchange between 2002 and 2019.
They find that over the observation period
the predictions of climate models,
warming trends inferred from futures prices
and observed temperature changes all coincided.
In other words, climate scientists
and market participants had similar expectations
which also aligned with the realized temperature change
over this period.
Another interesting place to observe
the pricing of physical climate risk
is in the municipal bond market.
Municipalities can't relocate
so we would expect municipalities
with more exposure to climate risk
to have a higher cost of capital if climate risk is priced.
A 2020 study by Marcus Painter titled
"An Inconvenient Cost:
The Effects of Climate Change on Municipal Bonds"
finds that higher exposure to sea level rise
is associated with higher municipal bond yields.
This effect is mostly driven by longer maturity bonds
suggesting that investors price the long term
expected effect of climate change.
The real estate market offers another laboratory.
A 2019 study by Bernstein, Gustafson and Lewis titled
"Disaster on the Horizon:
The Price Effect of Sea Level Rise"
finds that houses exposed to sea level rise
sell at a 7% discount to comparable properties
that are not exposed to the same risk.
Most of the discount is driven by houses
not at risk of being flooded for another 50 years
again, suggesting that investors
are taking a long term view of climate risk.
They find a smaller 4% discount
among properties not projected to be flooded
for almost a century.
The discount is grown over time
and is driven by sophisticated buyers
and communities worried about global warming.
The authors find no relation
between sea level rise exposure and rental rates
reinforcing the idea that the pricing discount
is due to expectations about future damage
not the current quality of the property.
Transitional risk can similarly be observed in asset prices.
A 2015 paper science and the stock market
investors recognition of unburnable carbon
finds that the stock prices of the 63 largest US oil
and gas energy firms fell by 1.5% to 2%
after the publication of a landmark paper
in the journal "Nature" arguing
that most fossil fuel reserves would need
to remain untouched to keep warming
under two degrees Celsius by 2050.
The finding implies that fossil fuel reserves
could become worthless if aggressive regulations
to combat climate change are put in place.
Markets reacted to the findings of the paper three days
after it was published, despite it not being picked up
by the media until much later.
Further evidence of priced transitional risk is found
in the 2015 paper
"Environmental Externalities and Cost of Capital"
by Sudheer Chava.
Chava finds that investors demand
significantly higher expected returns on stocks
that are excluded by environmental screens
such as hazardous chemicals, substantial emissions
and climate change concerns
compared to firms without such concerns.
Chava also finds that lenders charge a significantly
higher interest rate on the bank loans issue to firms
with these environmental concerns.
They also have lower institutional ownership
and fewer banks participate in their loan syndicate.
In the options market, Ilhan, Sautner, and Vilkov
find in their 2021 paper "Carbon Tail Risk"
that the uncertainty related to the future climate policy
needed to combat climate change is priced.
They find that the cost of option protection
against downside tail risks is larger
for firms with more carbon intensive business models.
And the cost of downside tail risk protection
is magnified at times when the public's attention
to climate change spikes.
The 2020 paper
"Climate Regulatory Risks and Corporate Bonds"
by Sautner, Starks, and Zhu
finds that firms with poor environmental profiles
or high carbon footprints tend to have lower credit ratings
and higher yield spreads particularly when located
in a state with stricter regulatory enforcement.
They use the Paris Agreement as a shock
to expected climate regulations providing evidence
of a cause of relation between climate regulatory risks
and bond credit ratings and yield spreads
and changes in the composition of institutional ownership.
Based on the literature that we just went through,
I'm pretty comfortable saying that climate risk is priced.
This should be reassuring for a couple of reasons.
If market prices reflect current climate risks,
investors are expecting returns commensurate
with the risk that they are taking.
If you wanna protect yourself from climate risk,
greener firms may be a hedge
against realized climate outcomes being worse than expected.
But this hedging property comes
at the cost of lower expected returns.
The evidence of climate risks being priced
is also good news for the world.
It suggests that there is a cost of capital incentive
for firms to manage their exposure to climate risks.
Now, I know what some of you might be thinking
at least you might be thinking this
if you've watched enough of my videos.
Should we build portfolios that load more heavily
on carbon intensive firms to increase expected returns?
It's a good question.
If climate change risk is a unique source of priced risk,
then loading more heavily to it could make sense
but this leads to another empirical question.
Does climate risk tell us anything more
about expected returns than other no one risk factors
like company size, relative price and profitability?
A 2020 paper by Wei Dai and Philip Maya Bronze titled
"Greenhouse Gas Emissions and Expected Returns"
examines data from the US developed ex US
and emerging markets from 2009 to 2018 for evidence.
They find that measures of emissions have no reliable effect
on returns after controlling for firm size, relative price
and profitability for stocks and for rates for bonds.
And that the cross sectional differences
in greenhouse gas emissions fail to predict
cross sectional differences in future profitability
once current profitability is controlled for.
Their finding suggests that the impact
of climate change on the expected returns
of high emission firms is well captured by existing prices
and proxies for expected future cash flows.
Sorry if that news is disappointing
but it should not come as a surprise.
The market is a difficult opponent to defeat
in an asset pricing competition.
And while our models for understanding
how the market prices assets are imperfect like any model,
they're pretty good.
Models like the Fama, French Five-Factor model
explain the majority of differences in returns
between diversified portfolios.
And as we've seen portfolios constructed
based on greenhouse gas emissions are no exception.
If the goal is increasing expected returns,
tilting a portfolio toward companies
with smaller size, lower prices
and robust profitability is a sensible way to go.
I described this in detail
in a video titled Five-Factor Investing with ETFs
and a Wite Paper of the same title.
I'm going to leave you with an idea.
There is a cost of capital incentive
for companies to reduce their exposure to climate risk.
Green companies, companies with low exposure
to climate risk have lower expected returns
because investors want to own them
and they offer a climate risk hedge.
They're higher prices already reflect this
only investing green companies
means expecting lower returns.
The other companies, the ones we wouldn't call green
have higher expected returns
because they're more exposed to climate risk
but that's not the whole story either.
If companies turn greener over time,
their cost of capital should decrease
and their expected cash flow should increase
increasing their price.
Why would companies turn green?
Because they want a lower cost of capital.
Incentives are funny like that.
As an investor it might feel good to own green companies
and expect lower returns for doing so.
But how about owning the less green companies too
and participating in their transformation
toward being greener?
I'm not saying all companies will eventually align
with your values, but the world's largest asset managers
like Vanguard and BlackRock have been exercising their power
through engagement with companies and proxy voting
with the view of managing climate risk.
The climate is changing, the physical and transitional risks
of climate change have the potential
to affect how businesses function in the future.
Investors owning companies exposed to climate risk
may be concerned about big losses
if these risks materialize.
It should be a concern but the evidence suggests
that it is a compensated concern.
Investors expect higher returns
for owning the company's most exposed to climate risk.
With engagement and proxy votes
from the largest asset managers
increasingly addressing climate risk
owning a total market index fund rather
than focusing on owning only green companies
might be the best way to do well by doing good.
Thanks for watching.
I'm Ben Felix, Portfolio Manager at PWL Capital
and this is Common Sense Investing.
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