Investors – it’s time to put your mouth where your money is

The collective wisdom of capital markets is probably still ‘in some doubt’ in many peoples’ minds at the moment. Interestingly though, from a green perspective, capital markets appear to have been estimating the likely costs of climate change to be higher than those predicted by cost-benefit analyses (such as the Stern Report) that have been much maligned by some industry lobby groups. And, of course, this implies that – even from a purely economic point of view – there is a case for stronger climate change mitigation policies than have been suggested by the cost-benefit analyses.

While business lobby groups represent the public positioning of business interests, arguably what owners of capital really think about global-warming might better be revealed by what they’re doing with their money. A study by Ronald Balvers, Ding Du, and Xiaobing Zhao attempts to discover – amidst the financial noise – what signal capital market investors are giving about what they think are the likely losses due to the effects of climate change. Looking at asset prices since 1976, they estimate that:

the risk premium [for global warming] is indeed significantly negative and becoming more so over time, that loadings for most assets are negative, and that asset portfolios in industries considered to be more vulnerable to global warming…have significantly stronger negative loadings on the global warming factor. We estimate that required returns on average are 0.11 percentage points higher due to the global warming factor, translating to a present value loss of 4.18 percent of wealth. The industry loadings appear to be unrelated to potential vulnerability to emissions regulation. Rather, the loss in wealth represents a general cost from increased systematic risk due to uncertainty in the extent and impact of warming and the increased incidence of extreme weather events…  (p.1)

They note that:

The majority of the research concerning the economic impact of global warming has emphasized the future effect on production or cash flows of an abrupt change in climate to occur sometime after the year 2050. (p.2)

But they take a different approach, focusing on the costs of gradual temperature change (such as increasing probability of extreme weather events).  These impacts have a greater economic value in part because they happen sooner – are happening now – so they don’t get reduced to practically nothing by the tyranny of discounting (p.3)

They note that:

…global warming (negatively) affects cash flows of firms in an uncertain fashion, acting as a (negative) supply shock. This shock should affect firms and economy not only by its impact on the level of cash flows, but also by its impact on the risk or uncertainty of cash flows and therefore the cost of capital. (p.4)

And that:

…ignoring global warming’s impact on the cost of capital may significantly understate its economic impact. Yet a review of the literature shows that there has been no research concerning the impact of global warming on the cost of capital. (p.5)

Their paper attempts to address this gap. Much of it is technical, but if the conclusions are correct, perhaps it is time for investors to start putting their mouths where their money is, and start pressuring politicians to adopt more agressive policies on climate change mitigation?

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