Climate and (Mis)calculated Risk

April 12, 2017

Scientists have confirmed that our climate is changing at an unprecedented rate and in dramatic ways. Our climate is intimately linked to the global economy—from farmers in Vietnam to real estate in Miami, almost every aspect of the global economy is exposed to the effects of climate change. For these reasons and more, cities, nations, and the global community are moving to mitigate their carbon emissions and are working to adapt to its projected effects. Yet there is another aspect of climate change risk that is often overlooked: the economic effects of policies designed to address the problem.

Carbon-intensive sectors do make a lot of noise about the supposed detrimental effects of proposed climate policies, often accompanied by terrifying projections of job losses and increases in electricity prices (see coal industry comments on the Clean Power Plan). Whether or not these projections pan out (they are often overblown), these policies do represent fundamental changes to these industries in the long run. However, the financial sector lags far behind in accurately accounting for the long-term impacts of climate change AND policies to address climate change when assessing corporate value.

The scale of this undervaluation is encapsulated in the concept of stranded carbon assets, also known as the “carbon bubble.” We can only emit a remaining 1,000 billion tonnes (Gt) of carbon dioxide by 2100 if we would like a chance at avoiding warming of over 2 degrees Celsius. On the other hand, there are an estimated 2,860 Gt carbon dioxide contained in the fossil fuel reserves listed as assets on the balance sheets of major extraction companies, not to mention the new reserves that are discovered and added to corporate valuations every year. A precautionary emissions pathway would leave 80 percent of global fossil fuel reserves stranded as unrealized value. This is good for the climate, but implies a painful financial readjustment. Ignoring this risk could drive significant financial losses that will reverberate through the global economy, akin to the housing bubble that triggered the Great Recession.

The problem contains elements of a few different market failures. For one, there is misalignment between corporate timelines and investor priorities (short), and the gradual, compounding nature of climate change and related policies (long). Second, the private incentive for each fossil fuel company to extract all its reserves is in tension with the communal target to stay within the global carbon budget, a classic tragedy of the commons. In these ways, climate risk is not accurately assessed in financial markets and citizens should look to government to address these market failures.

The economic fallout if we fail to adjust our accounts of corporate value will not be limited to the wealthy; rather, this will impact retirement savings, pension plans of public servants, college savings, and most of all will affect people that are already economically marginalized. Investors are beginning to take notice and to demand better disclosure of these risks, but the Security and Exchange Commission only suggests voluntary disclosure. As stated by Anne Simpson, Investment Director at the California Public Employees’ Retirement System (CalPERS), “[v]oluntary disclosure is swiss cheese – appetizing and full of holes. Investors need robust, mandatory reporting to capture climate change risks across their portfolios.” Mandatory disclosure of corporate exposure to the direct and indirect risks of climate change is an important preventative step towards limiting the financial impacts of climate change, but I wouldn’t hold my breath waiting for it.