Financial markets are mispricing climate risk

In a letter to Fatih Birol, the executive director of the International Energy Agency (IEA), I joined nine PRI signatories, including members of the new UN Net Zero Asset Owner Alliance, in calling on the IEA to “do better” following the release of their World Energy Outlook 2019 report.

The UN Net Zero Asset Owner Alliance signatories that signed the letter include CEOs from some of the world’s largest asset owners, who have recently committed to aligning their portfolios with net zero by 2050: Among them are AMF, Nordea Life & Pensions, Alecta, Allianz SE, PensionDanmark; Folksam Group; Storebrand; Zurich Insurance.

Given the IEA’s position as a leading authority for governments, investors and corporates, the letter set out how a reliance on their central scenario is creating a self-fulfilling prophecy that will see the world glide to at least 2.7 degrees of warming. But the major problem for investors today is that a credible forward-looking alternative for business planning does not yet exist.

Financial markets are mispricing climate risk

Alongside environmental concerns, the biggest worry for many is that financial markets are mispricing climate risk – exposing global economies to systemic risks and financial losses. According to a survey of investors by BNY Mellon, ninety-three percent of institutional investors believe climate change is not being priced into financial markets. The PRI’s own analysis shows that only two percent of our 2700 strong signatory base is “strategic” in their assessment and reporting of climate risk.

The IEA’s rebadging of its “central” scenario won’t help investors

This year, the IEA introduced a much-needed rebranding of its ‘New Policy Scenario’, which despite its name, assumed no new climate policies would be announced. The assumption remains, but it’s now much more aptly named as the Stated Policy Scenario (STEPs).

This renaming underlines the IEA’s stated aim for the scenario – to hold up a mirror to the disastrous environmental implications of the announced policy intentions of governments today.

Yet while policymakers certainly need guidance on the consequences of their current decisions as the world aspires to a 1.5C pathway, financial market actors also need a plausible outlook that considers how the future is likely to unfold in a realistic context of what policy makers are capable on achieving in the next few years. If not, they default to using STEPs to plan for a business-as-usual world.

This is the key problem which a simple renaming will not address – given the authority of the IEA and in the absence of a plausible forward-looking business outlook – countries, investors and companies will continue to rely on STEPs in their business planning. And, in the case of Exxon, explicitly use it to justify bullish oil growth. This means that, while the IEA points out that STEPs is simply a “scenario”, capital markets are in effect priced on it.

STEPs is a highly improbable scenario – and that matters

This scenario is also highly improbable leading financial markets to misprice climate transition risk and exposing global economies to systemic risks and financial losses

Business as usual will not continue for long as the realities of climate change catch up, social pressure mounts, and low carbon solutions get cheaper. So it’s highly improbable that governments will be allowed to let the world glide to 2.7C without being compelled into forceful action sooner.

The PRI foresee an “inevitable policy response” by 2025 that will be forceful, abrupt and disorderly because of the delay. This year, at PRI in Person in Paris, 59% of investors told us in a poll that they also felt this scenario was the most likely outcome.

The implications will ripple throughout the economy and create considerably greater disruption than many investors and businesses are prepared for today.

So, it’s time to get real about policy risks coming down the line in the next few years, and investors need tangible guidance which can help assess this latent risk in their portfolios. Longer term policy will need to push even harder to reach 1.5C

What’s the alternative? The launch of the Forecast Policy Scenario

To fill that gap, as part of the Inevitable Policy Response programme, and with input from our investor base, we commissioned Vivid Economics and Energy Transition Advisors to produce a major new global ‘Forecast Policy Scenario’ (FPS) which aims to deliver a reality-check to investors who assume governments will take limited action on climate change, while at the same time, provide them with a realistic forecasting tool to navigate this complex and evolving landscape.

We believe that the FPS is a realistic baseline tool for investors to follow, to be used as an alternative to the IEA STEP’s to inform forward-looking risk management, strategic asset allocation and company engagement.

It provides a high conviction, comprehensive and detailed picture of how the inevitable policy response to climate change will likely unfold, and then models how the global economy will be impacted by the forecasted policies.

Unlike other climate scenarios that are reverse-engineered from a pre-defined temperature goal – such as achieving well below 2°C – the FPS starts from a detailed, realistic and probabilistic assessment of policy and technology developments, taking into account current institutional and behavioural limitations. It does not assume that large amounts of yet unproven Negative Emissions Technologies can be deployed and is thus realistic about the challenge. It also includes macroeconomic, energy system, and land use models linking crucial aspects of climate across the entire economy, before breaking down implications at the macroeconomic, regional and sector level.

In other words, although we cannot be certain about future events, the FPS tool can help investors judge which developments are most likely in the near term, and act on the basis of this judgment. This means that rather than planning future investments on old policy announcements, investors can get a clearer picture of the climate transition risk latent in their portfolios and formulate their strategic asset allocation accordingly.

The time to act is now; if you’d like to you find out more about how you can get support on using the FPS please get in touch at [email protected]. To see the letter, which was sent to the IEA, see here: https://mission2020.global/letter-to-iea/.

 

 

This blog is written by PRI staff members and guest contributors. Our goal is to contribute to the broader debate around topical issues and to help showcase some of our research and other work that we undertake in support of our signatories.

Please note that although you can expect to find some posts here that broadly accord with the PRI’s official views, the blog authors write in their individual capacity and there is no “house view”. Nor do the views and opinions expressed on this blog constitute financial or other professional advice.

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