The acquisition of California-based Four Twenty Seven, Inc., by Moody’s Corporation could signify the beginning of a major shift in how markets price risks related to climate change. Up until now, these risks largely have been absent from investors’ models, but if Moody’s, a major rating agency, starts using Four Twenty Seven’s methods in assigning ratings, that might quickly change.
For a June, 2019 working paper, Zacharias Sautner of the Frankfurt School of Finance and Management and his collaborators Philipp Krueger and Laura Starks surveyed institutional investors on their climate risk perceptions. They found that while most investors aren’t climate change deniers, they tend to see the associated risks of their portfolios as reputational and ethical in nature rather than physical or financial. In other words, public disapproval and the possibility of government intervention are seen as more significant factors than the direct effect of climate change on businesses’ sales and profits. Only 26% of those asked incorporate climate risks into their valuation models and 25% hedge against them.
Most of the investors indicated to the researchers a belief that markets underestimate climate risks and thus overprice assets most exposed to them. But they also believe this effect to be small, while recent academic work points to significant mispricing. In a February, 2019 paper, Alok Kumar and collaborators showed that a firm’s climate sensitivity consistently predicts lower returns to investors in its stock, an underappreciated effect in the financial markets. A trading strategy taking it into consideration would have generated an annual return of 3.6% between 1939 and 2017, Kumar and collaborators calculated.
Four Twenty Seven is one of the pioneers in trying adequately to price climate change risks. In November, 2017 the Berkeley firm put out a joint white paper with Deutsche Bank’s asset management arm, in which it explained its approach to working out individual companies’ risk scores. It includes studying company sites and their exposure to heat stress, floods, wildfires, hurricanes and other extreme events that become more frequent as the climate changes, and figuring out how vulnerable the company’s suppliers and consumers are to the same phenomena given their predicted frequency. Before regulatory and reputational hazards even kick in, there’s the danger that fields and mines will be flooded, buildings ruined, supplies disrupted; in that sense, for example, a concentration of assets, especially in disaster-prone areas, should be a warning sign to investors.
Four Twenty Seven’s approach to pricing physical climate change risks is not the only one around. Moody’s itself has attempted to include estimates of this downside potential in determining sovereign risks. But the California firm has built one of the most comprehensive databases on the exposure of various assets – bonds as well as stocks. Integrating this expertise into Moody’s offering – if the rating agency indeed moves beyond buying Four Twenty Seven and letting it continue operating as before – would be a big step forward for the entire ratings industry. Up until now, it hasn’t used any kind of systemic approach to pricing physical climate-related risks, even as it has tried to incorporate climate factors into rating decisions.
The important leap for both analysts and investors to take here is to accept climate change not as a media and political phenomenon but as something that has a real effect on all aspects of life, including business. The science is increasingly unequivocal and precise. No, it’s not about normally changeable weather or any kind of natural climate cycles; the change is happening because of human activity, and it’s unprecedented in the last 2000 years.
This means the old paradigm of discussing climate change as part of so-called ESG (Environmental, Social and Governance) risks is inappropriate. The risks are increasingly physical and specific – the heat waves, the tsunamis, phenomena like the effect on Germany’s economy of two consecutive years’ low water in the Rhine. Models need to be adapted to them, new hedging opportunities created and ratings adjusted. It’s not a matter of fashion or reputation management but of basics like sales, cash flow and profit. Moody’s acquisition is a sign that the financial industry is beginning to take this on board.
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