Why aren’t markets repricing rising climate risks?

Misperceptions of the cumulative probability of climate-related events may be a big reason why markets have yet to appropriately reprice climate risks. We explain the math and share a new tool designed to help investors more accurately value securities exposed to climate change.

Views expressed are those of the author and are subject to change. Other teams may hold different views and make different investment decisions. The value of your investment may become worth more or less than at the time of original investment. While any third-party data used is considered reliable, its accuracy is not guaranteed. For professional or institutional investors only.

Key points

  • In many parts of the world, severe climate-related events that will affect capital markets are occurring more frequently.
  • We believe policymakers, market participants, and the public underestimate the cumulative probability of climate events.
  • We are developing tools that enable portfolio managers to assess the financial effects of climate risk at the security level.

MARK CARNEY, BANK OF ENGLAND GOVERNOR AND FORMER CHAIRMAN OF THE FINANCIAL STABILITY BOARD, ONCE STATED: “Past is not prologue, and the catastrophic norms of the future can be seen in the tail risks of today.” This notion is readily apparent in the context of climate change, where physical risks are rising with each passing year.

Secular shifts in atmospheric conditions are increasing the risk of severe climate-related events. This trend, which shows no signs of mean reversion, is the basis of our ongoing research with Woods Hole Research Center (WHRC) on the physical effects of climate change and their impact on capital markets. Our work with WHRC has found evidence that in many parts of the world, the  probability of so-called hundred-year events, including devastating hurricanes, supernormal rainstorms, and inland floods, is rising. Despite this trend, policymakers, market participants, and the general public appear to be underestimating the risks, including the potential for negative market impacts.

The continued mischaracterization of rare climate events as one-time occurrences rather than part of a changing pattern may be a reason why climate risk remains abstract, hampering proactive behavior, policy change, and asset repricing. We believe that if markets had better access to climate probabilities, particularly the cumulative risk of occurrence over multiyear periods, they would better appreciate the severity and accurately reprice these risks.

“Hundred-year” events do not mean “one and done”

A “hundred-year” event refers to one that has a 1-in-100 or 1% probability of occurring in a single year in a certain area. Some may incorrectly deduce that this means that a 1-in-100-year devastating hurricane, rainstorm, or flood will only occur once every 100 years. But probabilities aren’t limited to one-time occurrences. Even rare events can happen more than once in a set time period, so the cumulative probability of events rises more than what our intuition would expect. Brazil has already experienced two “100- year” droughts since the start of the century, while Houston experienced three “500-year” floods in the last decade. Many places vulnerable to climate change will face the growing…

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