How are climate risks priced in financial markets?
The Bank for International Settlements recently published a summary of the academic literature on the topic to show growing evidence physical and transition risks are increasingly priced in.
Although the impact of climate-related disasters over the past 50 years had little effect on financial markets, the BIS observes an evolution in climate risks assessments and highlights that:
- Investors mostly rely on incomplete and low-quality climate data, which enhances risk modelling challenges and uncertainty on how to address their consequences.
- Financial derivatives and specialised insurance markets are still unable to hedge climate risks because the effects of climate change are too uncertain and far in the future, leading to some risks being uninsurable.
- ESG ratings do not have a significant effect on pricing, especially because of the opaque and unstructured methodologies used to compute them and the lack of transparency of the underlying data.
- Climate policies are taken into account in the pricing of transition risks but are still underrated. Regulatory risks are identified as the top risk over the next 5 years, and physical risks the top one over the next 30.
- Equity and fixed income markets are both influenced by transition risks, especially through the anticipation and pricing of stranded assets.
The true social cost of these risks are not fully reflected yet due to uncertainty, imperfect information and externalities associated with climate changes and carbon emissions.
Still, policymakers and regulatory bodies are paying sustained attention to these topics and various linked ones, including systemic risks, impact of carbon taxes and regulation of carbon-intensive investments.