Climate change and market risks

2021-09-08 at 16:05 Timo Löyttyniemi

Phenomena stemming from climate change are attracting widespread attention. Last summer events such as floods in Central Europe and forest and bush fires across the world made it clear that insurance policies fail to cover all loss and damage. Many people would be happy if only everything could be insured – and affordably at that. Now that insurance is unavailable and the bill is footed by citizens, home and property owners as well as governments, the risks posed by climate change are brought home in highly tangible terms.

Traditional risks

Traditionally, markets have divided climate change related risks into two categories. The first is physical risks. They arise from flooding, storms, bush fires and other catastrophes resulting from climate change. Costs and expenses are often borne locally by citizens, businesses and the individual state hit by the disaster. As these risks become more common, it is increasingly difficult to obtain insurance cover.

Another category is transition risks. As societies increasingly reduce the use of coal, some will win and some lose. The losers are the industrial sectors that have failed to keep up with the developments and regulation through transformation. Two such sectors are energy and industry. An apt symbol for this is the old abandoned brick chimneys left behind by the structural change that has taken place in industry. New major risks – as well as opportunities – will also emerge in the marketplace as a result of the transition.

Risks associated with the transition path

Aside from these two traditional risks, the transition will also give rise to new risks that will materialise in the investment markets over the next two decades. The will to transition to a low-carbon economy is strong. However, it will be a bumpy road because the process will involve a range of risks that will surprise the investment and financial market.

One of the major risks related to the transition path is posed by the shifting policies pursued by governments. When a lot of things need to be done in a very short time, decision-making may be delayed or wrong decisions may be made in the absence of sufficient information. Often the political decision-making process itself generates compromises and less-than-perfect outcomes. All decisions will not prove optimal in retrospect. Corrective actions will be required over the years. Such volatile decisions may pose significant risks to investors. From the standpoint of the financial market, they may also result in imbalances and crises, if the scale of things is large enough.

The transition to a low-carbon economy will create a huge amount of new business opportunities. While the investments made by companies may well prove beneficial, the transition may also leave room for mistakes. Continuous advances are being made in technology, and green technology in particular. Tomorrow’s technology may reduce the appeal of today’s technology. Some of the once-promising projects will prove misguided.

As investors anticipate the transition to a low-carbon economy, security prices will reflect the dynamics of the new economy already today. The outlook may be overly optimistic. It is perfectly possible that the transition will take place over a completely different timeframe. Asset purchases and the policy of low interest rates pursued by central banks make future cash flows attractive and push up prices.

The indicators chosen by investors can and will change. Lately, investors have been greatly delighted by the new numeric indicators for companies and investment instruments. One such indicator is carbon intensity. Today, it is possible to determine a weighted carbon intensity index for a portfolio. Other indicators are available for other purposes. However, they may change over time. At some point, people will find that some other indicator captures the transition path more accurately. A case in point is ESG ratings. It appears that the ESG ratings determined by various institutions differ considerably.

Opportunity for reconstruction

The green transition is definitely an opportunity. One is tempted to predict that the transition to a carbon-neutral economy will turn into a major reconstruction project. Many things will change, and it will take cement, steel, timber and iron. The economic structures will be rebuilt – maybe not to the same extent as after the world wars but substantially anyway.

Conclusion

A transition towards a carbon-neutral economy is inevitable. Both governments and businesses are strongly committed to it. This offers huge opportunities for investors and the financial market. The transition will also involve risks. They will manifest themselves as fluctuations and potential crises in the financial markets. Be that as it may, let’s hope for wise decisions and a smooth path towards a low-carbon economy.

Link to a longer column on the same subject.

The writer is VER's CEO Timo Löyttyniemi.

TLö blogi 2020

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