Commentary: Markets can’t ignore climate change much longer

The $2 trillion infrastructure plan unveiled in March by the Biden administration marks a key turning point for U.S. climate policy and signals a heightened commitment to combating climate change by the U.S. government. Until recently, climate risk was a distant externality, largely uncaptured by market mechanisms and only partially reflected in asset prices. This dynamic is changing rapidly, spurred on by government interventions like the Biden administration's plan, alongside several other competing forces. Globally, climate risk will be increasingly reflected in market prices, leading to a potentially dramatic repricing across asset classes, sectors and companies.

Indeed, it is no longer a question of if this repricing will occur. Rather, the real question is whether the transition will be an orderly one over time ushered in by government measures, better climate analytics and gradual market adjustments, or an abrupt, jarring decline in market sentiment triggered by a climate "Minsky moment" — a sudden, all-at-once adjustment in asset prices.

A range of climate transition risks has already begun to be reflected in market prices for heavily regulated, high-carbon sectors such as energy, utilities and transportation. European Union policies designed to quantify the costs of carbon-intensive goods or services have forced markets to account for future transition risks in today's pricing. The implementation of phase 2 of the EU's emissions trading system contributed to Europe's two largest utility companies (RWE and E.ON) and losing roughly 90% of their value between 2008 and 2016.

There has been a similar repricing of coal, with global coal assets losing value and coal companies trading at the lowest enterprise value/EBITDA and second-lowest average trailing price-earnings ratio of any industry globally (after regional banks).

There is still a long way to go. In the U.S., for example, Miami faces significant risk of flooding, affecting potentially $8.7 billion worth of residential property alone. Property taxes account for 35% of Miami's annual operating budget, yet investors continue to buy local municipal debt with seemingly no climate discount.

There are several factors that discourage markets from pricing in climate change today. First, what former Bank of England Governor Mark Carney referred to as "the tragedy of the horizon." That is, the most catastrophic impact of climate change will be felt beyond the typical horizon of most traders and investors.

Second, there is broad awareness that climate change will lead to more extreme climate events like typhoons and hurricanes. However, a lack of specificity on the timing and location of these extreme events has led to a lack of urgency.

Third, markets tend to do a poor job pricing in non-linear risks and often simply ignore such threats before they reach tipping points.

Government action, such as emissions trading systems, has played a key role in altering the economics of carbon-intensive assets, leading to a broader market repricing. As more jurisdictions adopt climate policy initiatives, a more complete repricing of transition risk is likely to occur. For example, China's ambitious carbon emissions trading regime, which launched earlier this year, is poised to drive significant repricing of its utilities.

Looking beyond government policy, however, investors will find numerous other compelling reasons for markets to more fully recognize the risks around climate change. Several dynamic factors are emerging to wake markets out of their climate slumber and acknowledge the externalities of carbon emissions and climate risk.

First, advanced climate analytics and modeling are finally becoming more accessible and granular for investors. Indeed, the last few years have seen the beginning of a "data revolution" for investors around climate analytics. While still in its early stages, the data trend allows investors to better quantify climate risk and differentiate between companies within an industry. This kind of relative valuation tends to lead to a gradual repricing of assets.

Second, changes in the preferences of investors and consumers are also driving repricing of climate risk across firms and industries. Alternate protein manufacturer Beyond Meat has launched substitutes for both pork and beef in Asia. Driven by changing consumer values around sustainability, demand for plant-based meat alternatives is projected to grow by 200% over the next five years in markets such as China and Thailand, according to a DuPont forecast.

Finally, there have been enough obvious climate change-driven anomalies and disasters that market participants can no longer ignore them. In Australia, bush fires ravaged the country in 2020 and consumed more than 83 million acres. Also, the most recent Atlantic hurricane season produced more named storms than any prior season. These global climate phenomena only serve to amplify local awareness of climate risk.

The factors noted above are likely to spur gradual or partial repricing of climate-related risks.

However, policies take years to materialize, consumer preferences don't change overnight and new data gets introduced bit by bit. In the absence of these gentle nudges that accumulate over time, markets may see abrupt and disorderly price changes, which could come in the form of one massive transformative event. According to one estimate, a singular climate-inspired "Minsky moment" could lead to global financial losses of up to $20 trillion, according to the Bank of England.

The U.S. infrastructure proposal is just the latest sign that policymakers are ready to make significant investments to protect against climate risk, a trend that is likely to accelerate in the coming years. However, markets have yet to fully account for the sweeping economic transition brought about by climate change. When the pricing transition occurs — be it gradually or abruptly — there will be major implications for all investment portfolios. Savvy investors will navigate the risks and identify the opportunities in this altered investment landscape.

Shehriyar Antia is the head of thematic research at PGIM. He is based in New York. This content represents the views of the author. It was submitted and edited under P&I guidelines but is not a product of P&I's editorial team.