Markets Are Grappling With Pricing Climate Risk: Bank of England

Whether it’s physical or transition risk, investors are are often stumbling in the dark.

Markets Are Grappling With Pricing Climate Risk: Bank of England
Photo by NOAA / Unsplash

Despite data and modeling advancements, investors have little confidence that any asset is appropriately priced given the rapidly escalating risks of climate change, according to a new Bank of England paper.

Structured as an overview of current research, BoE authors say that investors lack the tools to quantify and, as a result, adequately hedge climate risks could hurt investors in the long-term.

“While studies find that these risks are starting to be priced, concerns are growing that current prices do not fully reflect the risks,” the report states. “Uncertainty and imperfect information complicate pricing.”

While physical risks are broadly incorporated in market prices today, the research argues that their use is “mixed and insufficiently comprehensive.” For example, International Monetary Fund data says the inclusion of physical risks, such as natural disasters, has been “modest” over the past half century when pricing equities and there are only “preliminary” steps to pricing the risks in credit markets.

Transition risk also needs additional scrutiny given investor exposure, especially in the energy sector.

“Transition risks present challenges for firms operating in high-carbon sectors as they might erode valuations, increase operating expenses and lead to balance sheet deterioration through reduced collateral values and stranded assets,” the BoE says. “Even though there is some evidence that transition risks are priced in financial markets, it is unclear whether this pricing is sufficient to address transition risks effectively.”

More advanced economics are hedging their climate risks through derivatives and insurance structures, but even those solutions face their own challenges given the rapid increase in weather and climate induced losses.

“Hedging climate risks presents unique challenges for insurance companies and investors,” the paper says. “Many effects of climate change are so uncertain or so far in the future that neither financial derivatives nor specialized insurance markets are available to directly hedge these risks. Furthermore, while heterogeneity across exposures can in principle allow for certain risk-sharing arrangements, some climate risks are considered uninsurable.”

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