Macroeconomic & Geopolitical

Hell, Heaven & the Next Bonanza of Mispriced Assets

March 2021 – 3 min read
While markets focus on post-pandemic recovery, regulators have been sounding the alarm on the need to price in long-term climate risk.

Let’s be honest. There are some, in this mercenary world of global finance, who embrace Environmental, Social and Governance (ESG) goals as a means of avoiding hell—having chosen such a gloriously self-enriching career. Others don't actually believe in heaven, but sense there has been a shift in polite society that favors ostentatious displays of pious behavior.

But amid important conversations about how best to align social values with investment strategies, the keen-eyed investor will also see a bonanza of mispriced assets coming into view. As most of us have been concentrating on lockdowns, vaccines, and the next few months, the world’s financial regulators have stepped up their calls for markets to stare long and hard at the looming costs and opportunities from climate change. 

Earlier this month, the Bank of England added fighting the climate crisis to its traditional mandates of price stability and economic growth. The Bank of Japan announced in February that it would begin including climate considerations in its examinations. And last December, the U.S. Federal Reserve added its considerable heft to the Network for Greening the Financial System, a global effort by financial regulators to improve the management of climate risk.

“This is not mission creep,” in the words of European Central Bank President Christine Lagarde. “It’s simply acknowledging reality.” 

The “reality” is that climate change has triggered an epic shift in risks and prices. The scientific evidence links human activity to heatwaves in Sweden, flooding in Bangladesh, and hurricanes in the Caribbean. By one estimate, natural disasters in Europe caused more than €210 billion in damage last year alone. We have already seen the bankruptcy of a California power company triggered by environmental disaster. It’s not hard to imagine serious financial disruption from a bank with too much exposure to coastal property or an insurance firm overwhelmed by storm claims. 

Beyond obvious potential for losses, central banks worry about changing dynamics of productivity and capital flows as climate damage accelerates. Worker output may deteriorate amid rising heat stress, investment choices may shift radically to build resiliency against extreme weather, and market volatility may make monetary policy transmission much less predictable. 

If these dangers sound distant and terrifying, climate-related opportunities are coming more clearly into view as governments gear up to invest vast amounts and speed the transitions they have announced to reach net-zero carbon emissions by 2050. 

We’ll get a first hint of the Biden administration’s plans for a zero-emissions energy grid by 2035 at a climate summit next month, but a clearer picture will emerge when Congress considers trillions of dollars in new infrastructure and climate investment. Over the next few years, the European Union’s Recovery Fund earmarks hundreds of billions of euros for green investments, while China’s plans to add renewable energy to its power grid will emerge in more detail with the implementation of its 14th Five Year Plan.

Meanwhile, as oil companies fret that a post-pandemic world of less travel and preference for electric vehicles may leave them with stranded assets, the march of technological progress continues to improve the attractiveness of renewable energy.

Investors may grumble that these changes are too slow and abstract to price in, but regulators are increasingly warning them to put on their thinking caps and sharpen their pencils. 

Starting in June, the Bank of England will force its banks to begin searching for alternative scenarios that may emerge from these global trends. “Investments that look safe on a backward look may be existentially risky given climate risks,” says Governor Andrew Bailey. “And investments that might have looked speculative in the past could look much safer in the context of a transition to net zero.”

“Investors may grumble that these changes are too slow and abstract to price in, but regulators are increasingly warning them to put on their thinking caps and sharpen their pencils.”

While not yet requiring raising fresh capital against climate risks, Bailey is pushing for some serious grappling with the hazards ahead. “Uncertainty and lack of data is not an excuse,” he says.

Of course, assessing long-term potential for damage is difficult because the climate science itself remains uncertain about what to expect with each degree of warming. Still, policies to create a better market-derived price for carbon emissions will help shift incentives. Almost as important will be reliable and comparable disclosures from firms about their own climate-related risks, and efforts are underway to address that, too.  

There are signs that market forces are already beginning to gain traction assessing climate risks. The ECB announced last fall it would start accepting some “green bonds” as collateral for refinancing operations, giving an extra boost for European issuance that is already robust. Brewing giant Anheuser-Busch InBev announced a $10 billion revolving loan that becomes more expensive if the firm doesn’t meet certain sustainability targets, including emissions.

The scientific and policy choices ahead are vast, but assessing future climate risks and putting a price on them is, after all, what investors do for a living. And it’s not as if markets ever have anything more than a dim shadow of the future. Indeed, any discounted cash flow calculation rests on some pretty heroic assumptions around prices, margins, and “terminal values.” 

Climate-risk assumptions look even more heroic today, but making them integral to investment analysis is the next big step for regulators and central banks. And as any wise investor knows, the best returns come from staying a step ahead.

Christopher Smart, PhD, CFA

Chief Global Strategist & Head of the Barings Investment Institute

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