• The Supervisor

Jan 30, 2024

How climate change will impact investment decision making

Inaugural mandatory climate statements due out over 2024

This year marks the beginning of publishing mandatory climate statements for climate reporting entities (CREs) as required under Part 7A of the Financial Markets Conduct Act 2013 (FMCA). Of Trustees Executors’ supervised entities, the CREs concerned are listed debt issuers and managers of registered schemes that meet the defining criteria set out in Part 7A. The first round of climate statements is due for lodgement with the Registrar of Financial Service Providers by no later than 30 April 2024.

These new climate statements will be keenly awaited for what they contain, as there is some uncertainty as to the correct approach to take. Some CREs have already been voluntarily making climate-related disclosures (CRD) in past years and so have a measure of practice behind them. The External Standards Board (XRB) has published voluminous information on the official standards that are required to be met by climate statements, but it is still up to each CRE to work out how it will go about tackling the task now that it is mandatory and subject to complex and detailed regulation.

It is one thing to publish climate statements, and another to find some practical use for them. Theoretically, climate statements, just like financial statements, are supposed to help enable efficient allocation of capital on rational grounds. With financial statements, investors can analyse them to decide whether to buy, hold, or sell their investments, which influences their portfolio compositions and investment strategies. Climate statements are meant to achieve the same end, but based on a different set of criteria than financial statements rely upon. The audience for both types of statements is various, but investors within it will range widely between large institutional entities with billions of dollars to allocate and massive research resources at their disposal to mum-and-dad KiwiSaver scheme members drip-feeding from wage or salary.

Just as financial statement literacy is required to help enable investors to make fully informed investment decisions, so too will climate statement literacy need to be developed. No doubt there is an industry for climate statement literacy teaching waiting in the wings, but even if people can read and understand the information that these statements are communicating, there is still an inevitable problem arising in translating that understanding into effect through investment actions that rationally implement efficient capital allocation. Presumably the likes of the Financial Markets Authority (FMA) will be undertaking market research across the range of New Zealand’s investors to find out whether mandatory climate statements are working as intended.

Precision versus uncertainty in climate risk estimation for investment purposes

An academic paper published late last year addresses the issue of how climate change information literacy – or lack thereof - affects investors and markets. The position paper, Portfolio Losses from Climate Damages: A Guide for Long-Term Investors, (Paper) is by Riccardo Rebonato, who is Scientific Director of the London-based EDHEC-Risk Climate Impact Institute and Professor of Finance at the EDHEC Business School. Professor Rebonato leads the EDHEC-Risk Climate Impact Institute’s “Impact of Climate Change on Asset Prices” research programme, so should know a thing or two about how to match up climate change information with investment decision making.

The Paper primarily addresses technical points about Integrated Assessment Models, most particularly of the Dynamic Integrated Climate Economy (DICE) model, that are used to estimate economic impacts of climate change, including economic damages, but otherwise is well and wittily written in such a manner that the lay reader can readily grasp what the key considerations are concerning practical uses that investors may have for climate change information. The investors the Paper discusses are trustees of UK pension funds, particularly of local government pension schemes, but logically other investors could be substituted in such as may be found in New Zealand.

It is not necessary within the context of this article to consider the intricacies of using DICE methodology to try to predict economic damages under different climate scenarios as is analysed in detail within the Paper. Professor Rebonato’s key point on DICE is that it has been misused to produce climate risk estimations that are unduly certain and precise in their estimates of potential climate-induced economic damages. He is further concerned that these estimations are also probably systematically understated, with a detrimental impact on investment portfolio construction. The implication is that pension fund trustees and their consultants are insufficiently climate change information literate and underprepared for the possibility that climate risks and resulting economic damages will turn out to be greater than has been modelled and applied to portfolios via DICE methodology.

The Professor is of the view that aiming for great degrees of precision in estimating climate scenario outcomes is unrealistic and misleading, and that pension fund trustees should instead be informed by their consultants that such estimates are intrinsically highly uncertain. Rather than aiming for precise answers, he believes that probabilistic analysis of climate risk outcomes such as economic damages is more appropriate. Within this context, the Professor sharply criticises the use of misplaced precision:

Given how deep the uncertainty is, the precision with which the pension consultants have communicated their return projections to the trustees – sometimes presented with so many significant figures that they reach the hundredth of a percentage point! – is not only scientifically unjustifiable, but counterproductive and dangerous, because it engenders in the non-expert recipients the impression that these projections can be known with the stated precision.

(Paper, p. 19)

Practical application of climate scenarios to investment decision making

An important point that Professor Rebonato makes early on in the Paper that is relevant to how investors might read climate statements is to distinguish between climate scenarios and financial scenarios:

For the advice provided to pension fund trustees [on climate risk and consequent economic damages] to be actionable, the various portfolio outcomes must be associated with at least order-of-magnitude estimates of the probabilities of their occurrence: climate scenarios are in this respect different from financial scenarios.

(Ibid., p. 6)

The Paper spells out in terms of asset class combinations how misinterpretation of climate change information can skew investment portfolios towards suboptimal performance:

… [T]here is no ‘safe’ way of being wrong in financial decisions, as the consequences of an overly prudent investment policy can be as deleterious as the effects of an excessively optimistic one: the more defensive the strategy, the greater the tilt toward cash, short duration and limited credit risk, the lesser the exposure to equities – historically, a recipe for underperformance.

(Ibid., p. 20)

In the conclusion of the Paper, Professor Rebonato expands upon how climate scenarios are wholly different from financial scenarios and, therefore require a different approach to understanding and using them effectively for making investment decisions:

… [T]he key piece of information that we think is missing in the advice the pension fund trustees have received: a clear description of the huge degree of uncertainty surrounding the impact of climate change on asset returns. Being cognisant of the degree of uncertainty in returns can in itself radically change an investment choice, and the make-up of a portfolio. And, as we have argued, there is no safe way to be wrong: the investment consequences of taking as certain the most severe damage projections are as severe as the results of over-optimistic strategies, and manifest themselves in terms of underperformance (as finance theory teaches, buying insurance requires giving up a risk premium). And investment professionals would be immensely helped in their portfolio-construction task if they were provided with the approximate relative probability of different climate outcomes: in this respect, as we have argued, climate scenarios are radically different from financial ones.

(Ibid., pp. 26-7)

Conflicts between experts confusing investors

The Paper demonstrates the wide scatter of projections for climate change-induced economic damages arrived at by reputable economists to counter a charge that these experts are subject to “groupthink”.  It also acknowledges that the economic damages projections of climate scientists are generally more aggressive than those of economists. Some academics argue that more weight should be placed on the projections of climate scientists than of economists on the ground of superior expertise. However, the expertise of climate scientists lies with projecting physical outcomes of climate change, whereas the expertise of economist’s rests with projecting economic outcomes. How physical and economic projections are to be reconciled in portfolio construction remains an unresolved problem in the Paper.

Professor Rebonato argues against the notion that climate scientists are necessarily more accurate than economists when it comes to predicting the economic damages of climate change:

… [T]here is no doubt that scientists understand the complexities of climate physics better than economists, who are pure ‘consumers’ of the complex climate models. But we do not consider as self-evident that the estimates produced by climate scientists about economic damages should necessarily be better than the estimates from economists. The present-day complaints by climate physicists that economist do not understand the economic implications of climate change bear an eery resemblance to the claims by ecologists in the late 1970s that the economists of the time did not understand the economic effects of the finiteness of natural resources.

(Ibid., p. 20)

As the Professor points out, it was the economists and not the ecologists of the 1970s who were eventually vindicated in the argument over whether or not the world was running out of natural resources. In the current round of dispute over who is right – economists or climates scientists – over the economic damages that climate change might cause, the Paper essentially supports the view that the contending camps should stick to their knitting – economists to economics and climate scientists to climate science. In the conclusion section the Paper suggests that the experts should communicate better with each other:

Finally, we certainly agree that the economics and physics communities would benefit from interacting more closely (both ways, of course) … neither scientists nor economists can understand all aspects of a problem as complex as climate change, and should help each other in their respective areas of expertise.

(Ibid., p.27)

This aspirational objective of greater inter-disciplinary co-operation does not have any obvious application to portfolio construction based upon the correct understanding and application of climate change information. For investors seeking answers as to whose expertise to rely upon, the Paper does not have clear-cut recommendations beyond keeping in mind the inherent uncertainty of all climate change-induced economic damages projections and seeking to obtain realistic probabilistic estimates for adverse outcomes.  How to select from competing and conflicting views among economists and climate scientists is not within the scope of the Paper.

Are markets asleep at the wheel?

The fifth section of the Paper is headed up with the above question. Therein Professor Rebonato examines a much wider question than whether the trustees of UK pension schemes are as fully informed and climate information literate as they should be. The Professor warns that markets may be complacently underestimating climate risk and its economic damages. He states that, “the current prices of equities and traded debt seem to incorporate very little information about climate change: in a way, it seems as if the market endorses the consultants’ views about the quasi-irrelevance of climate change for valuations” (Ibid., p. 23). There are only two explanations for this state of affairs, the Paper argues:

  1. Either the market counts on an extremely efficient management (via adaptation and abatement) of climate change;
  2. Or it believes that a significant change in climate will not materialise.

The Paper proceeds to consider how likely either of the two explanations are. For the first, which presupposes “an unprecedented rewiring of the whole economy [that] would have to occur over relatively short horizons” (Ibid., p. 23), it conducts a brief review of the academic literature on evidence in asset markets for “sectoral return differentiations”, “climate beta” and “greenium” that would signify pricing for climate risk. It finds the evidence from such empirical studies of both “green assets” and “brown assets” to be inconclusive. The Paper states:

It is difficult to reconcile such a weak and elusive dependence of asset classes and sectors on climate innovations with the deep and urgent transformations that a successful management of climate risk requires. So, from current asset prices, it is difficult to extract the message that the market believes that the major transformations needed for a deep and rapid decarbonisation of the economy will take place.

(Ibid., p. 23)

As for the second explanation, the Paper argues that the market is wrong to place confidence in benign climate change outcomes:

Staying within the Paris Agreement’s ‘1.5°C by 2100’ aspirational target is now almost impossible, and we are nowhere close to being on course for the 2.0°C target. What lies beyond these levels of temperature increases is little known, but should give rise to serious concerns: after all, the species Homo Sapiens, let alone human civilisation, have never experienced temperature anomalies of 3°C.

(Ibid., p. 23)

In sum, Professor Rebonato does not believe that markets are pricing in climate risk and consequent economic damages sufficiently because they are taking excessively optimistic views of either how much climate change will occur or how quickly technological innovations will enable sufficient adaptation and abatement. As such, market prices would appear to be inflated. As a result of his concerns about climate risk discounting, the Professor expresses a precautionary view:

If market prices do indeed discount overly optimistic climate or adaptation outcomes, a disconnect between valuations (based on expectations) and realisations of cashflows cannot continue indefinitely. This means that there is the risk of a repricing. Whether this repricing will be gradual and orderly, or sudden and chaotic, is obviously impossible to tell, but a benign adjustment should not be taken for granted.

(Ibid., p. 23)

For investors, the ability of markets to discount climate risk efficiently should be a matter of great importance. If the Paper’s view is correct on the actual state of climate change and that markets have failed so far to discount this change correctly, then there is potential for significant and possibly unrecoverable investment losses at some stage in the future. The section on markets ends with a warning to investors:

From the perspective of a portfolio manager (and hence of a pension fund trustee) this repricing risk should be a real concern, and should also be part of the climate information provided to investment professionals. In the 4°C scenario analysed by the pension consultants, for instance, it is by definition the case that the climate-change problem has not been successfully managed, and the repricing of securities to reflect the scenario reality becomes much more likely. This message should be part of the information provided to pension trustees. However, this does not seem to be happening.

(Ibid., p. 24)

The Paper’s assessment of the state of markets is pessimistic. It assumes that good quality, comprehensive climate information is not being provided to investors and that they are not sufficiently climate change literate to know this. As a consequence, it is likely that investment portfolios are not sufficiently robust to withstand large-scale losses in the not improbable event that climate change risk turns out to be worse than markets are discounting. Perhaps market participants believe that the economic damages of climate change are too remote or insubstantial to be concerned with, or possibly the financial reporting cycle with its near-term focus on profits is still highly dominant versus longer-term climate risk considerations. If it is true that markets are not adequately signalling climate risk through their pricing, then that would make it even more difficult for investors to make sense of climate change information such as will be provided through mandatory climate statements due a disconnect between market valuations and forecasts of economic damages.


“The practical applications for mandatory climate statements will come under the microscope as they first start to be published over 2024,” said Matthew Band, General Manager of Trustees Corporate Supervision at Trustees Executors.

“Climate statement literacy will be required so that investors can rationally participate in the efficient allocation of capital.”

“The Paper by Professor Rebonato gives some useful insights into the types of problems that investors could encounter as they try to apply climate change information to investment strategy and portfolio construction.”

“There are potential investment return costs either way in being either too climate risk averse or not enough.”

“Professor Rebonato captures well some of the key problems for investors in grasping the uncertainty of climate change-induced economic damages projections, understanding how to use outcome probabilities, and selecting and reconciling competing and conflicting expert opinions in order to devise successful investment activities.”

“The notion that markets are sleeping at the wheel as climate change threatens long-term investment returns is a possibility too serious in its implications to ignore.”

“Supervisors will need to keep abreast of how their supervised clients such as listed debt issuers and managed investment scheme (MIS) managers are dealing with climate risk within their investment strategies.”

“It is to be hoped that mandatory climate statements will assist in this task, as well as enabling investors to make better quality investment decisions.”

For comment or more information, or to be added to the free email subscriber list of “The Supervisor”, please contact Matt Band at [email protected].

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