With more countries being overwhelmed by climate change-related events, one wonders how big of an impact this will have on the world of investments, and how investors will need to take climate risks into account when making allocation decisions. During the Inquire Europe autumn seminar, Mathijs Cosemans addressed these issues in his presentation based on research from his paper ‘Climate Change and Long-Horizon Portfolio Choice: Combining Theory and Empirics’, written in collaboration with Mathijs van Dijk and Xander Hut. Here, he provides long-term investors a novel approach to integrating physical climate risks into their investment process.
For those who were unable to attend his presentation, a summary has been made:
“Recent survey evidence shows that the main climate risks for investors over the next five years are transition (regulatory) risks. However, for the next 30 years, most investors indicated that the top climate risk will be physical, as we can expect that the physical risks of climate change will materialize over a longer period of time.
This brings up the problem of measuring the exposure of assets to long-term climate risks. This will be difficult to do because our historical data sets are not yet very informative; we haven’t had that many aggregate climate shocks yet compared to the scenario that global warming increases in the future. We would expect the impact and frequency of climate driven disasters to increase, and this should have an effect on economic growth and asset prices.
As a result, investors will face large uncertainty about the magnitude and the long-horizon impact of climate change on asset prices. The uncertainty investors face can be summarized by this quote by Professor Robert Stambaugh: ‘Expand the horizon to the next several decades, and the possible effects of global warming range from negligible to catastrophic’. We still face this uncertainty, on the level of impact but also on the extent of climate change, with varying views from different investors.
This is where our research comes in. We wish to study the impact of the different investor beliefs of the financial impact of climate change on the perceived riskiness of equity markets and on portfolio choice, particularly for long-term investors like pension funds. What we aim to demonstrate is how to construct an optimal portfolio given your beliefs about climate change, or in other words, how to integrate your beliefs regarding climate change in to your portfolio.
We show that buy-and-hold investors who derive their beliefs from an asset pricing model that considers the impact of global warming on future economic growth perceived stocks to be riskier over longer periods of time than investors who ignore climate change. This heightened perception of equity risk reduces the long-horizon stock holdings of these investors, as the associated increase in risk is not completely compensated by higher expected returns.
Furthermore, heterogeneity in views on the impact of climate change also results in sizeable differences in the optimal equity allocation of long-term investors employing dynamic portfolio rebalancing. For investors with uncertain or uninformed views on climate change, stock holdings increase consistently as the investment horizon extends. For investors with beliefs based on asset pricing theory, the presence of climate risk diminishes equity allocation because it creates a negative hedging demand that grows with the horizon”.
View the research in full via: https://www.inquire-europe.org/event/autumn-seminar-2023/