With climate change and ESG investing all over the news, a recent white paper by Dimensional assesses the academic literature on climate science, and economics and finance, including the implications of climate change for asset pricing and investment choices.
Overall, the literature provides compelling evidence that the impact of climate change risk on asset prices is captured well through the valuation framework, suggesting that investors can use current prices and reliable proxies for expected future cash flows to identify and pursue systematic differences in expected returns, according to Dimensional’s paper, “The Economics of Climate Change.”
The 32-page paper first reviews the basics of climate science and the historical evolution of greenhouse gas emissions, and then discusses the relation between climate change and economics, and assesses the economic costs—direct and indirect—of climate change. It then turns to the tradeoffs associated with different potential actions, such as carbon taxation and cap-and-trade programs, with a final examination of the implications of climate change for asset pricing and investment choices.
“Measures of climate risk might be useful for the pursuit of higher expected returns only if they contain reliable information about the cross section of expected returns beyond the information contained in current prices and profitability,” explain authors Mathieu Pellerin, Jacobo Rodriguez and Joseph Chi.
They further note that there is a growing body of evidence showing that prices across many different markets—stocks, bonds, climate futures, equity options and real estate—incorporate information about climate risk. “This pattern is consistent with the behavior we would expect in competitive markets: buyers and sellers have incentives to use all the information at their disposal to value assets, and the literature suggests that information about climate change is no exception,” they state.
In the valuation equation, the paper explains that information about climate risk is likely to affect not only discount rates but also future cash flows. For example, consider the possible introduction of a carbon tax. Such a tax would plausibly lower the expected cash flows of emission-intensive firms, the paper notes. At the same time, if the timing and magnitude of the tax are unknown, uncertainty could increase discount rates for firms vulnerable to the impact of the tax, with both effects potentially leading to lower asset prices for emission-intensive firms, the paper further observes.
“We believe that, while not perfect, the market does a good job of incorporating publicly available information into prices,” the authors state. “This includes information about variables investors disagree on and variables that are hard to forecast, such as inflation, unemployment, economic growth, and changes in regulation.”
The authors further note that they know of no compelling evidence that this observation does not hold for ESG-related risks, including risks related to climate change. “Overall, the evidence from academic research supports the predictions of valuation theory and shows that market prices reflect information about climate risk.”
As part of their concluding remarks, the authors observe that, when analyzing the implications of climate change, economic reasoning offers a “powerful unifying framework,” noting that investors, policymakers and citizens must all grapple with the uncertain effects of climate change and weigh the costs and benefits to find the best course of action.
As for the implications for security selection, the paper suggests that ample empirical asset pricing research shows that climate change considerations and their expected effect on a company’s business are incorporated into asset prices and do not appear to contain additional information about expected returns.
“In our view, a systematic and broadly diversified investment approach that focuses on reliable drivers of expected returns (size, value, and profitability in equities and forward rates in fixed income) remains the most reliable way for investors to pursue higher expected returns,” the authors emphasize.
These results are also encouraging news for everyone concerned about climate change, the authors notes, observing that financial markets seem to pay attention to climate risk despite its complexity. Moreover, competitive market forces provide firms with incentives to better manage their exposure to climate risk to reduce their cost of capital.
