The State of Climate Risk in Project Valuation
Kenny Grant and Calvin Qiu discuss the state of climate risk in project valuation, including current developments and potential challenges in this new but growing area of investigation.
Transcript
[00:00:36] Kenny Grant: Hello, my name is Kenny Grant. I'm a managing director in BRG's Boston office. And joining me in this episode of BRG's ThinkSet podcast is Calvin Qiu, a director in BRG's Singapore and Hong Kong offices. Welcome, Calvin.
[00:00:51] Calvin Qiu: Thank you. It's great to be here, Kenny.
[00:00:54] KG: Today, we're going to discuss the state of climate risk in project valuation, including current developments and potential challenges in this new but growing area of investigation.
[00:01:06] CQ: Yeah, this is a very important area today, especially as discussion around environmental, social, and governance issues—better known as ESG—is heating up. Personally, I don't like this term that much, since it's a catchall umbrella term covering many things that should be dealt with separately. But here we are.
The financial impact of climate-related risks and opportunities is becoming increasingly relevant to investors, given the increase in extreme climate events and shifts in attitudes and policies towards climate change.
[00:01:46] KG: I agree, and that's a great place for us to pick up. So, just to make sure our listeners are on the same page, what I'd first ask, Calvin, is if you could give some historical context around the relationship between climate risk and valuations. And you started to touch on this, but let's expand it a little bit more. Why are valuations only starting to account for these risks now?
[00:02:06] CQ: Right, so that's a good question. The global impact of climate change has been studied by climate scientists and economists for quite a while—in fact, decades—but it's only more recently that valuation practitioners or regulators or academics have really started to take this into account at a more asset-specific level.
So—just to go back a bit in history—looking at this from the perspective of economics, greenhouse gas emissions are recognized as a classic example of what's called market failure. Specifically, the costs associated with emitting greenhouse gases to the atmosphere are not borne by the emitter, but those impacts affect everyone across the globe. So, what happens is the emitter doesn't internalize those costs that are put on to others. And when left to their own devices, markets alone can't get us to a quote-unquote “optimal level” of emissions.
Because this is seen as a market-failure problem, one of the ways to address this requires some form of regulation. And there have been efforts at market-based solutions—for instance, carbon taxes and cap-and-trade schemes. These put a price on greenhouse gas emissions. they force the emitter to internalize those costs. However, these market-based solutions have been quite limited outside of Europe. But in recent years, especially in the last decade, there's been more adoption across the world. So, Asia, Japan, Korea, and China have some form of carbon taxes or cap-and-trade schemes in place.
While climate scientists have made a lot of progress in modelling the global impact of greenhouse gases, the ecosystem is very complex with many feedback loops. There's a lot of uncertainty in terms of specific ways in which climate change is going to affect individual projects of businesses. And this is compounded by the fact that how climate change is going to look is going to depend on how we respond to it.
I guess what's different right now is that the world is starting to see the very tangible impact of climate change. Here, I would like to introduce two concepts, and those are physical risks and transition risks. Starting with physical risks: to use an example, I'm very fond of coffee. And the quality of coffee is highly dependent on the soil it is grown in and weather conditions. One of the problems that coffee producers around the world are now facing is that climate change is threatening traditional coffee producing areas. As climate impacts are becoming more tangible, these producers have to take into account the effect of climate into their business decisions.
And as for transition risks, these speak to changes in areas such as policy, technology, and consumer sentiment that are responding to climate change. For instance, car manufacturers have to factor in policy and consumer shifts in many countries toward EVs [electric vehicles].
[00:05:40] KG: I'd add a couple of points to this timeline that you laid out. The first would be Mark Carney's famous 2015 speech, “Breaking the Tragedy of the [Horizon],” in which he connected the market's lack of action as regards the risk posed by global warming to a potential Minsky moment. Now I know that you know what a Minsky moment is, but let me just provide a little bit of context for listeners. A Minsky moment refers to a sudden collapse in asset values. The stylized example would be the economy is overleveraged, investors wake up one day, realize that, and there begins a disorderly selling of assets. And there's a rapid decline in asset values, which flows through the financial markets and has ripple effects across the macroeconomy.
What Mr. Carney did was basically say there's a parallel here where investors become aware too late of the impacts of climate change on their portfolio of holdings, which leads to a period of sudden adjustment in financial asset values. That is, a disorderly selloff of assets with the potential risks and consequences for the financial markets as a whole.
Not surprisingly, and this is my second point here, we begin to see regulatory and other public institutions begin to address the incorporation of climate-related risk in financial disclosures. So they're asking firms to put forth better information—more transparent information around climate risk. The most well-known may be the Financial Stability Board's Task Force on Climate-Related Financial Disclosures, or the TCFD as it is commonly known, put forth its recommendations in 2017. It provides a framework by which climate-related risks and opportunities are assessed over different time horizons and different pathways that would be the speed and disorderliness by which policy is enacted by regulatory authorities. With that, I think the rules are becoming mandatory, but they're not completely set, and they're largely building on TCFD recommendations.
And I was wondering here, if you could just touch on what's happening in the UK and maybe the EU, and I could touch on what's happening in the US.
[00:07:59] CQ: Sure. Taking the UK as an example—it's the first G20 country legislating disclosure requirements that are more or less aligned with the TCFD recommendations. The law mandating climate disclosure came into effect April 2022. Similarly, in the EU, they have passed the Corporate Sustainability Reporting Directive, and member states are expected to enact laws by mid-next year that would carry certain disclosure requirements.
[00:08:29] KG: Now, the US is a little bit behind. The Securities & Exchange Commission has offered a proposed rule. It's in the comment phase right now. It, too, largely follows the TCFD framework, but we do not have a finalized rule yet. Now, all of that to me speaks to transparency, but of course comparability also matters for the purposes of information quality that investors need to make their investment decisions. And we're starting to see actions that try to ensure comparability across disclosure requirements. For example, the International Sustainability Standards Board and the EU's Corporate Sustainability Reporting Directive, each in their own way, are working toward bringing harmonization across the disclosure requirements, so investors can be assured that they're looking at comparable information across different firms to better inform their capital allocation decisions.
Okay. So, we have these new disclosure requirements in place, and let's assume the information is there, and the logical next question then is: how is the information to be factored into valuation analysis? And I'd like to get your take on that, Calvin.
[00:09:46] CQ: Sure. So, you mentioned comparability. There's an organization called the Network for Greening the Financial System, or NGFS. They are a network of central banks and regulators. They developed a range of plausible climate scenarios that can be used as common baselines for scenario testing. And, by the way, scenario testing is one important part of TCFD recommendations. So, the NGFS scenarios can be divided into four quadrants, depending on whether physical risks are low or high and whether transition risks are low or high. An example would be a current policies scenario, which is a kind of business-as-usual scenario. It belongs to a quadrant called Hot House World, which has high physical risks combined with low transition risks.
Now, the challenge is that, in order to fully incorporate these scenarios into valuations, investors would have to assign probabilities to these scenarios, which is inherently very challenging because we don't really know at this point where we will end up. So, how to do this systematically still seems to be somewhat of an emerging field. There's a gap in terms of how information disclosed is to be converted into financial risk metrics that are relevant for valuing a firm or a project.
But some organizations have been trying to advance these practices; for example, in the UK, the Climate Financial Risk Forum, comprising major asset managers, banks, and insurers. Earlier this year, they published a paper called Climate Disclosures Dashboard 2.0, where various climate-related disclosure metrics are placed on the dashboard. And there are some metrics relating to financial impacts, which are probably the most relevant for valuation. They are not yet well developed or widely accepted. Examples of such metrics include climate value at risk, which measures the potential negative impact on different businesses or sectors, depending on which climate scenario we are in. Another metric would be climate-adjusted probability of default.
So, Kenny, I'm aware that there's emerging academic literature that's trying to assess whether climate-related risk is actually being accounted for by investors, and that's an area that you are very familiar with. Is there current consensus on this?
[00:12:44] KG: I would say: sort of and kind of. First, I'd note that the literature is really in its infancy. We have less than ten years—and that's generous—of academic research in this area. It's growing, but it's still relatively new. With that caveat, I would say the academic literature falls into two broad categories: those papers that look specifically at asset prices and those that consider risk premia.
Let me start with the asset prices. This literature, which writ large, looks at historical prices of specific assets to assess whether—and if so, to what extent—prices of those assets appear to reflect climate-related risk. So, for example, it might look at the relative price of specific assets related to some climate-related impact, such as real estate prices and the projected rise in sea level.
The other common technique is what we refer to as an event study. And so, look at the impact of, say, the enactment of the Paris Accords on brown firms versus green firms. You sort of define what a brown firm is, what a green firm is, and then look at the impact on their valuations.
A couple of surveys look across this nascent literature and are showing that, yes, by and large, asset prices are starting to account for climate-related risk. That's sort of consistent with my own anecdotal data from conversations with private equity representatives and institutional investment firms, where climate-related risk is just beginning to be factored into the analysis. I tend to get a sort of, “Yes, it is, but we know it's not thorough,” or, “We're starting to consider this, but we haven't figured out the methodologies yet.”
The second bucket would be the risk premia, and here the research is more mixed. It's asking, is there a risk premia, and if so, what is it capturing? And, as you know, one significant challenge here is—for investors—risk is forward-looking. Yesterday doesn't matter. The world is known; we know what happened. To an investor, what matters is what's going to happen tomorrow and the day after, and there's where the uncertainty arises. This is compounded by the fact that climate risk is still emerging. And as you noted up top, translating the global models down to the asset or firm-specific impacts still presents methodological challenges.
There are papers that have found that long run uncertainties in global temperatures are impacting equity values. But it's still really quite nascent. The general answer is yes, but it's still very early in this area of research.
The deeper question is whether climate risk is fully or even appropriately accounted for. And, of course, that question isn't really knowable. But that said, the consensus among academics, regulators, and practitioners is generally thought to be, "No, climate risk isn't yet fully accounted for." But I don't really find that surprising given the conversation that we've had here today. The informational challenges and methodological gaps are still being worked out. So the fact that there's still uncertainty—no pun intended—around this issue isn't surprising. We're all trying to figure this out.
Now that said, I would like to touch on the methodology a little bit before we leave here, Calvin. And, in particular, I'd like to talk about discount rates and what impact that has on investors' incentives. Could you speak to that?
[00:16:31] CQ: Sure. Just as a very brief intro to discount rates, investors have to weigh money across different points in time. Generally, $1 today is worth more than $1 tomorrow. And the way to bridge that difference is through the use of discount rates. What happens though is, if there's a climate-related harm that's far off in the future, then investors don't tend to assign that much weight on those harms.
And this is compounded by rising interest rates recently. In a rising-interest-rate environment, there's much greater emphasis on the present versus the future. So, if there's a climate impact that's quite uncertain—it's only expected to materialize in the future—then that's going to feature less in the investors' decisions or in their valuations. But as we discussed previously, as these impacts are becoming more tangible, then investors have no choice but to take them into account.
One thing to keep in mind, though, is that in the increasing interest-rate environment, there's a potential divergence between how private investors view discount rates and how policymakers view discount rates. In policymaking, policymakers would have to weigh benefits and costs today and tomorrow. And the way they do that is to use social discount rates, or SDRs. However, the theoretical considerations for SDR used by policymakers are quite different from those used by private investors in financial discount rates. So, for instance, SDRs may involve the consideration of ethical or philosophical issues such as intergenerational equity. And what often happens is, SDRs tend to be lower or else equal. Because if policymakers use high discount rates, over long periods of time, then what effectively happens is the welfare of future generations just doesn't really enter into the decision-making. So, they tend to use lower SDRs. But in an increasing interest-rate environment, private investors’ discount rates are going up. So there might be a divergence.
[00:19:34] KG: You know, I think that's an incredibly important point in today's environment, where we're asking the financial markets to do more and more [in regard to ] accounting for climate risk. And yet there is this inherent tension, as you note, between private discount rates and social discount rates.
With that, I, first, would say thank you very much. And as we wrap up the episode, I'd like to ask if you have any parting thoughts on the future of climate risk and asset valuations.
[00:20:01] CQ: Sure. I think the consideration of climate impacts in asset valuations is not really going to go away, especially in a world where we are looking at increased transition risks as governments or consumers are taking actions in response to climate change. We are also seeing a lot more physical risks. But what about you, Kenny? What do you think we can see over the coming years in this space?
[00:20:31] KG: I think your comment is right on point. This is not going to go away, particularly [in regard to] climate risks. I would note there's a consensus across climate-impact models, whether they're produced by private companies, NGOs [nongovernmental organizations], or governments. All lead to the conclusion that meeting the standards set forth in the Paris Agreement is going to require additional action on the parts of government; that is, there's going to be more regulatory or governmental intervention into the market. And that in itself is a complicated process and leaves investors with the challenge of having to assess the who, when, where, and how associated with that conclusion. The risks aren't going to go away. I think they are going to increase as we move forward.
So, with that, Calvin, thank you very much. I think that's a great note to end on, and we'll leave the listeners with that.
[00:21:21] CQ: Thank you, Kenny.
[00:21:23] KG: And if you want to learn more about this topic, please visit thinksetmag.com.