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Efficient Market Theory Is Working: Investors Price Securities With Climate Risk In Mind
Dimensional Fund Advisors finds that climate risks are baked into the markets already, even those that may not appear for decades.
Chalk one up for Efficient Market Theory, a hypothesis that the prices of stocks and other assets reflect all available information.
Although evidence is accumulating about the effect of climate change on everything from weather patterns to human health, scientists can still only paint a partial picture of the future. Nonetheless, stock, corporate and municipal bond, futures, and options markets are doing a good job of incorporating climate risks into asset prices, despite the complexity and uncertainty.
In recent research, which includes a review of outside academic studies, Dimensional Fund Advisors sought to address the question of whether and how well climate risks are priced into different markets. Dimensional looked at how the markets priced both physical risks and transitional risk, which arises as economies move away from fossil fuels and to a low carbon economy. The new research grew out of Dimensional’s study of the economics of climate change published in October.
“Many of the effects are hard to predict, hard to quantify, hard to bring to the present in terms of value or cost,” Savina Rizova, the firm’s global head of research, told Institutional Investor. “First, financial markets do pay attention to these risks, despite the complexity and even the longer run effects of climate change. Second, companies have incentives provided by competitive financial markets to better manage their exposure to climate risks if they want to have a lower cost of capital.”
Rizova said one of the academic studies she reviewed focused on municipalities. “You can’t avoid the physical effects of climate as a physical entity,” she said. The study found that municipal bond yields are higher for places with higher exposure to the risk of rising sea levels. “But the majority of effects is found in long maturity bonds, which speaks to the fact that markets do reflect the considerations about the longer run risks of climate change,” she added.
Dimensional found similar evidence from academic studies about the housing market. The prices of houses that are more exposed to rising sea levels compared to housing without those risks sold for a 7 percent discount. But markets aren’t just incorporating short-term information. Most of the discount can be attributed to houses that won’t be exposed to flood risks for at least the next 50 years. “You see that markets are thinking about the longer consequences of climate change,” said Rizova.
In its study, Dimensional also cites a paper published in the journal Nature in 2009, which sent the stock prices of 63 U.S. oil and gas companies down by 1.5 percent to 2 percent within three days of its publication, even though it wasn’t publicized by the mainstream press until years later. The Nature article argued that most fossil fuels would have to be left alone if global warming was to be kept under 2 degrees Celsius by 2050. The signal for investors in these companies was that fossil fuel reserves still in the ground would be worthless if countries met that standard and therefore the stocks should be worth a lot less.
Rizova said she also found that markets are very much in line with objective scientific evidence. One study of climate futures traded on the Chicago Mercantile Exchange between 2002 and 2018 found that warming trends predicted by scientific climate models, warming trends inferred in the price of climate futures, and actual rises of temperature over the period all coincided. “That tells you that first the climate futures market reflects expectations in line with scientific models, and second, in general the participants in climate futures don’t systematically overestimate or underestimate future warming trends,” she said.
Investors interested in owning securities that don’t contribute to climate risk may not need to own funds with an ESG label.
Rizova said Dimensional, which constructs its funds based on efficient markets theory, expects its broadly diversified investment strategies to have more value coming from companies somewhat insulated from climate risk than from at-risk companies. “It’s inherent in the price,” she said.
Some investors, however, may want funds that are more focused on sustainability and have a portfolio where they see a measurable reduction in greenhouse emissions, she said.
[II Deep Dive: What Happens When a Company Gets an A From One ESG Rater and an F From Another?]
One issue that has been raised by Dimensional's research is the role of ESG ratings services, whose rankings are often wildly divergent from one another. Investors who rely on these to build portfolios may not be getting what they want, said Rizova. Relying on market forces may be a better alternative.
Dimensional is currently working on a paper on the economics of corporate governance and the costs and benefits of different approaches, including stewardship, activism, and proxy voting. Next year the firm’s research team will study the economics of social issues.