How Financial Markets Can Grow More Climate Savvy

By: Jenessa Duncombe

Take extreme weather risks into account, and markets could prove hardier in a changing world.

Energy investors looking to steel themselves against topsy-turvy market transitions could try something new: factoring extreme weather risks into their investments.

At present, financial markets may be failing to account for the physical risks of extreme weather from climate change. That’s a problem, according to Paul Griffin, an accounting professor at the University of California, Davis, because overpricing could lead to an extreme correction to the market down the road.

“If the market doesn’t do a better job of accounting for climate, we could have a recession—the likes of which we’ve never seen before,” Griffin said in a press release.

On the other hand, if markets do adjust and societies reduce emissions, “a couple of generations from now, we might have a more stable planet,” Griffin told Eos. “This is something that will benefit generations beyond ourselves.”

Although researchers are just starting to understand possible links between market pressures of the coronavirus crisis and the climate crisis, Griffin said that lessons learned may help with climate-related transitions. Crude oil prices plunged below zero this week, and the pandemic has revealed weaknesses in global supply chains.

But unlike the market’s “forward-looking” response to the pandemic, the costs associated with climate change “are far more distant,” and the markets have a “tough time” grappling with them, Griffin said. In the long-term, addressing climate risks “is much more important than what we’re going through now,” Griffin added.

Invisible Risks

Energy firms are at particular physical risk due to climate change, yet they’ve been slow to price these risks.

Many energy firms have infrastructure in vulnerable areas. The Gulf Coast, where numerous oil refineries are located, is facing rising seas and more extreme storms. Southern states are also seeing skyrocketing temperatures, which threatens worker safety. California and other western states are exposed to arid air and wildfires, causing power disruptions.

Despite these vulnerabilities, investors and asset managers have been “conspicuously slow to connect physical climate risk to company market valuations,” Griffin wrote. Company stock prices do not reflect these risks, and it’s unclear whether insurance will provide cover. Future litigation could also prove costly.

“This is an issue that needs to be addressed, so the markets correct themselves in a reasonable or orderly basis,” Griffon said. If they don’t, a correction all at once “can be very horrific for markets.”

The Great Recession is the “best analogy” of the present situation, according to Griffin. A sudden correction to the market from unpriced risk in the subprime mortgages kicked off the financial crisis in 2007, which in turn triggered the Great Recession that rippled around the world.

Making a Shift

To avoid a large market correction from extreme weather impacts, investors need to pin down the exact risk from future events. Extreme weather risks pose a unique challenge for climate risk modelers because some investors normalize extreme weather impacts over time. Some emerging companies, like Jupiter Intelligence and Four Twenty Seven, could work to fill this gap, and others could work to make data digestible for investors and asset managers.

Recently, Norway’s Government Pension Fund Global divested part of their fossil fuel holdings, and the Saudi Aramco corporation began offering some public shares. “For investors and asset managers, the Norwegian and Saudi actions are a further sign of climate risk underpricing,” Griffin wrote in his comment in the journal Nature Energy earlier this year.

Jesse Keenan, an associate professor of real estate at Tulane University, said that the shift could help markets bear the risks of future transitions as well. “Advancing more disclosure on the physical risks (e.g., generation facilities, transmission equipment, etc.) could be catalytic for forcing greater analysis of the transition risks, which are closely interconnected,” noted Keenan.

Factoring climate change into market decisions is difficult, said Griffon, because “you’ve got these massive costs that are far more distant that the markets have a really hard time grappling with.” Moving forward will take both political will and a responsive judicial system to tackle the task, said Griffin.

This story was originally published in Eos Magazine and is republished here as part of Covering Climate Now, a global journalism collaboration strengthening coverage of the climate story.

Lead image courtesy of Freepik.