Climate Transition: An Unpriced Risk?

Global - Jan 31 2019
  • #carbon
  • #carbon/climate change
  • #climate
  • #credit risk

Climate Transition: an unpriced risk?

“I often say that when you can measure what you are speaking about, and express it in numbers, you know something about it; but when you cannot measure it, when you cannot express it in numbers, your knowledge is of a meagre and unsatisfactory kind.” (Lord Kelvin, 1824-1907)

Climate change poses a number of risks to investors and to the financial system, but the steps taken to address climate change can also cause instability. According to Mark Carney, governor of the Bank of England, climate transition risk can be defined as “the financial risks which could result from the process of adjustment towards a lower-carbon economy" (2015). Indeed, given the urgency of action required for countries to respect their commitments from the 2015 Paris Agreement and limit climate warming to 2°C by 2100, climate transition risks are becoming increasingly important. A first question arises: how to quantify this uncertainty around the climate transition path? To answer this, we examine a climate debt approach proposed by the Observatoire français des conjonctures économiques (OFCE). We will look how this indicator, combined with more traditional financial indicators, can help monitor the sustainability of sovereigns. Finally, we will focus on different investment cases, given the fact that this emerging risk seems to be unpriced at date.

Quantifying Climate Transition Risk: A First Approach with Climate Debt

In December 2018, the OFCE published "An Explorative Evaluation of the Climate Debt". The authors provide a preliminary quantified approach of the climate transition risk in monetary terms for EU countries.
The main hypothesis is that, once the carbon budget is depleted, and in order to respect its commitments, the country implements abatement measures which reduce its remaining emissions to zero overnight and for the remaining years before reaching carbon neutrality. It is based on the strong hypothesis backstop technology exists that can reduce emissions to zero once the carbon budget is depleted. These assumptions allow the authors to convert a carbon budget expressed in billions of tonnes of CO2 into a monetary measure, i.e. the cost of abatement (abatement cost times emissions to abate). As it is a flow, the authors used a Net Present Value to transform it into a stock, i.e. the climate debt, using a standard discounted sum with a discount rate representing the social rate of time preference. This new quantitative indicator, expressed as a share of GDP, enables to refine the concept of sustainability.

Looking for a Sustainable Path

Dividing the graph below into quadrants, we can identify the relative positions of countries regarding both financial and climate transition sustainability:
(Note: For the sake of simplicity, we define financial sustainability as a low debt-to-GDP ratio and climate transition sustainability as a low climate debt-to-GDP ratio.)
  • A: countries with high financial sustainability but on an unsustainable climate transition path;
  • B: countries with high financial unsustainability and on an unsustainable climate transition path;
  • C: countries with high financial sustainability and on a sustainable climate transition path;
  • D: countries with high financial unsustainability and on a sustainable climate transition path.
Climate vs. Financial Debt: A Comparison
Sources: IMF, OFCE

Unfortunately, no countries within the sample can be defined as being on a sustainable path from both a financial and in terms of a climate transition perspective. Germany’s case is particularly interesting as it is the least-indebted country in financial terms, but it will face high degrees of climate transition risks when moving towards a lower-carbon economy.

An Unpriced Risk

As the graph below indicates, there does not appear to be any relationship between bond yields and climate debt. Thus, it seems that climate transition risks are actually unpriced or at least mispriced.
Dividing the graph into quadrants again, we can distinguish as many investment cases:
  • A: countries with high government bond yields but on a sustainable climate transition path;
  • B: countries with high government bond yields and on an unsustainable climate transition path;
  • C: countries with low government bond yields and on a sustainable climate transition path;
  • D: countries with low government bond yields but on an unsustainable climate transition path.
Bond Yield and Climate Debt
Sources: Datastream, OFCE

Countries in the C area are then safer compared to countries in the D area relative to climate transition risks. Regarding the climate transition risk only, it would then be most valuable to invest in France and Spain rather than the United Kingdom and Germany. A 2°C compliant investor could then consider switching from German to French bonds in its portfolio.

Improving Financial Markets Information

Regarding the mispricing of climate transition risks, there is a need for improved financial markets information. The OFCE’s work on climate debt is a first step, as a quantitative indicator is needed in order to assess this emerging risk. We could also consider using a social cost of carbon in order to measure this climate debt rather than cost of adjustment, the first being a notion more widely shared. However, research is still needed in order to evaluate and investigate the macro-financial impacts of this risk. Will this risk lead some governments to default in the future? What about the case of corporates? These questions need to be addressed, and quickly!

Thomas Lorans, Economist
Sources: Beyond Ratings, OFCE, IMF, Datastream
 
 

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