Guest essay by Eric Worrall
The International Monetary Fund is concerned rich people and money managers are ignoring their climate warnings.
Investors ignoring climate change risks, IMF warns
John Kehoe Senior writerMay 29, 2020 – 11.00pm
Sharemarket investors are failing to properly price in the risk of climate change inflicting damage on companies and economies, a new analysis by the International Monetary Fund has warned.
The Washington-based fund’s Global Financial Stability Report examines the impact of climate change physical risk on financial stability, including the loss of life and property as well as disruptions to economic activity.
The IMF analysed equity valuations across countries in 2019 and found that they did not reflect any of the commonly discussed global warming scenarios and associated projected changes in hazard occurrence or incidence of physical risk.
“This apparent lack of attention by investors could be a significant source of market risk looking forward,” said IMF financial counsellor Tobias Adrian.
“We need to step up climate-change stress testing and scenario analysis more generally as essential tools of climate change risk management.”
…Read more: https://www.afr.com/policy/energy-and-climate/investors-ignoring-climate-change-risks-imf-warns-20200529-p54xp8
The following is the introduction to chapter 5 of the IMF report;
PHYSICAL RISK AND EQUITY PRICES
Chapter 5 at a Glance
- The impact of large climatic disasters on equity prices has been modest in the past.
- Climate change physical risk does not appear to be reflected in global equity valuations.
- Beyond climate change mitigation and adaptation, sovereign financial strength and higher insurancepenetration help to preserve financial stability.
- Stress testing and climate risk disclosure are essential to better assess physical risk.
The projected increase in the frequency and severity of disasters due to climate change is a potential threat to financial stability. Equity markets are a key segment of the global financial system, provide a data-rich environment, and are sensitive to long-term risks, making them fertile ground for investigating how projected future physical risk affects financial markets and institutions. Looking back over the past 50 years shows a generally modest impact of large disasters on equity markets, bank stocks, and non–life insurance stocks, although country characteristics matter. Higher insurance penetration and greater sovereign financial strength have helped dampen the adverse effects of large disasters on equity markets and financial institutions. While projections of climatic variables and their economic impact are subject to a
high degree of uncertainty, aggregate equity valuations as of 2019 do not appear to reflect the predicted changes in physical risk under various climate change scenarios. This suggests that equity investors may not be paying sufficient attention to climate change risks. Beyond policy measures to mitigate and adapt to climate change, actions to enhance insurance penetration and strengthen sover- eign financial health will be instrumental in reducing the adverse effects of climatic disasters on financial stability. Moreover, better measurement and disclosure
of exposures to climatic disasters are needed to facilitate the pricing of climate-change-related physical risks.
I used to work in finance. The investment managers I met didn’t trust the ability of models to predict the future, they used their models to understand the present. Ask the right questions over a few beers with a portfolio manager and they will tell you all sorts of cautionary tails of failed high fliers and bankrupt CEOs who mistook their model projections as reliable predictions of future market conditions.
Everyone I met in finance knew the story of Long Term Capital Management, whose spectacular crash defined the recklessness and financial model mania of the late 90s.
Despite the fund’s prominent leadership and strong growth at LTCM, a 2014 Business Insider article pointed out that there were skeptics from the very beginning:
Investor Seth Klarman believed it was reckless to have the combination of high leverage and not accounting for rare or outlying scenarios. Software designer Mitchell Kapor, who had sold a statistical program with LTCM partner Eric Rosenfeld, saw quantitative finance as a faith, rather than science. Nobel Prize winning economist Paul Samuelson was concerned about extraordinary events affecting the market.
Economist Eugene Fama found in his research that stocks were bound to have extreme outliers. Furthermore, he believed that, because they are subject to discontinuous price changes, real-life markets are inherently more risky than models. He became even more concerned when LTCM began adding stocks to their bond portfolio.
When climate scientists approach fund mangers, many of whom are top of the class Math and Physics PHDs, and tell them they have a model which can predict the future, I suspect that is a big red flag for people who have seen it all before.