Climate Risks and Market Efficiency

Jun. 15, 2016

Do markets price in climate risks brought on by climate change? That was the question on 18 May when Harrison Hong, Professor of Finance and Economics at Princeton University and Frédéric Samama, Amundi shared their insights with an audience at the Swedish House of Finance.

Harrison Hong with colleagues recently performed a study called “Efficient Pricing of Drought?” in which they investigated the links between drought, food company cash flows and their stock price performance. They decided to focus on drought since it was found to be the most destructive weather phenomena for food production.

– Our findings indicate that markets are not efficient but instead underreact to climate risks. Droughts were associated with lower increases in profitability for food production companies over the next year and a long-short strategy based on the drought index Palmer Drought Severity Index (PDSI) would thus generate a nine percent alpha with a sharpe ratio of 0,5 according to our study, said Harrison Hong.

The study confirms regulatory worries that markets do underreact to climate risks and the need for disclosures of corporate exposures could be a way forward as this might improve market functionality.

Frédéric Samama shared his experience as asset manager dealing with climate risks. At Amundi they are increasingly working with assessing and mitigating the effects of climate risks on investments and believe that the importance of this work will only grow with time.

Climate change is now perceived as a real risk for long-term investors but financial innovation allows investors to handle the risks. Low carbon indexes for example, could help reduce risks over the long run without impacting market exposure over the short run, said Frédéric Samama.