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A Hotter Planet Is Already Warping Asset Prices




Climate change will have severe consequences for the global economy, including through rising seas, increased hurricane activity, droughts and wildfires. But the biggest economic cost may be the increased frequency of heat waves, which raise the energy costs of air conditioning and reduce the productivity of many types of workers, especially those whose jobs require outdoor work.

New research led by New York University economist Viral Acharya attempts to measure how these costs are already reflected in stock prices, corporate debt and municipal bonds. The researchers found a significant effect of exposure to heat stress on all three. I spoke with Acharya and one of the co-authors, Thomas Tomonen, assistant professor of finance at Boston College. Below is a condensed, lightly edited transcript of the conversation. Their paper, co-written by Suresh Sundarsan of Columbia University and Timothy Johnson of the University of Illinois, can be found here.

Jonathan Levine: What are your main points?

Viral Acharya: The first finding is that across markets, the physical climate risk that appears to be priced – statistically and economically significant – is exposure to heat stress. Second, we find that the economic magnitudes are very large when standardizing the distribution of physical climate risks across municipalities or businesses. One standard deviation in variance appears to contribute, in the case of municipal bonds, to something in the range of 15-20 basis points. [per annum in muni bond yield spreads]. In the case of sub-investment-grade corporate debt, anything within 40 basis points. And in terms of the cost of capital in an equity issue, it’s also something in the order of 40 basis points per year. Although not earth-shattering, I would say those amounts are still respectably large which we have associated with physical climate hazards.

JL: Has the market always recognized the additional risks from climate change?

VA: Pricing for physical climate risk appears to be more consistent both economically and statistically — at least in the data and using our methodology — starting around 2013-2015, depending on the testing and which markets we’re looking at. There could be many reasons for this. One could be that the risks of heat stress have actually increased in the recent past, so the appearance of this risk in the cash flows of municipalities and corporations has caused the market to price this risk.

JL: What about the broader investor awareness of future risks?

VA: The risk has probably always been there, but somehow with the activity of investors, multilateral agencies, think tanks, NGOs, etc., there is probably some learning and more awareness of these risks in the markets. In any case, the fact that these risks are priced more for sub-investment-grade companies, the fact that they have been priced more recently and the fact that they are priced higher due to heat stress rather than risks like hurricanes or droughts in which adapting can be difficult. Easier prospect, we think all of this gives us reasonable confidence that we’re picking up on what it’s like to pricing physical climate risk.

JL: Can you explain what investors might think of demanding higher risk premiums for these securities?

VA: At the end of the day, our measurements of physical climate risk are measures of these companies’ expected losses. For example, at the county level, what is the impact on employee productivity in high-risk sectors such as construction and mining, where thermal stresses make it difficult for them to work? Even if there are some mitigation strategies like air conditioning, it will add significantly to your energy expenditure. These are the losses that have to be incurred, and they will affect your cash flow.

JL: Please tell us exactly how physical climate risks are affecting the country.

VA: In the case of municipal debt, where we think adaptation isn’t really possible — you can’t change the location of the municipality — we think naturally the effect is there. We expected the country to show pricing of physical climate risk. We find even in Mooney’s case that the effect is stronger for sub-investment-grade debt, but interestingly enough it’s also stronger for long-term debt because you’d expect climate risk to be kind of like disaster risk, which increases in its cumulative frequency of access over a long period. We also find that pricing is stronger in yield-only bonds and not in general obligation bonds – general obligation bonds have a greater variety of cash flows.

JL: What about companies?

Virginia: Companies can move their locations. They can move their sales, employment and production intensity in different factories. However, what we found is that in the case of heat stress, although adaptive, especially for sub-investment grade debt, the effect of exposure to heat stress is very large. Now, we don’t find a similar effect from other physical climate hazards such as hurricane exposure, such as being on the coast, or exposure to specific areas of flooding and drought. We think one rationale for this result may be that it is not difficult to move your plants from the coast line a little inland, for example, while the gradient of exposure to heat stress moves very slowly geographically. There are only large pockets of cases in one set which are somewhat of a heat hazard. Now you have to completely radically change your site. Sometimes that can mean fundamentally changing your business model. As if you were a Midwest farming business, it’s not like you could move to the Northeast, for example.


JL: And why do you think physical climate risk is priced significantly in riskier securities?

VA: There appears to be an impact on cash flows which then affects the probability of default risk. And where does it matter most? It’s even more important for companies that are already poorly rated to start.

JL: Can we find a cheaper way to provide air conditioning or figure out how to cool and shade construction workers to keep them healthy and productive?

Virginia: The cheap way to save on air conditioning is also not emissions-friendly. So switching away from CFCs means air conditioning has also become somewhat more expensive.

Thomas Tomonen: Air conditioning is a bit like the big way humans adapt to climate change, but the result of intensified cooling is actually exactly what a lot of the climate science literature thinks is ultimately the most expensive climate change once you take into account that type of adaptation. Of course, if we could find a renewable and inexhaustible source of energy, this problem would probably go away, but to the extent we can’t, there doesn’t seem to be any easy solution to this kind of increase in energy demand.

JL: Is there an example of what the costs of heat stress look like in the real world today?

VA: These things are very interesting in a world where energy and fuel are also experiencing sharp increases at the same time. For example, in an emerging market like India, where I come from, every summer there is a very heavy burden of power-sharing in the country. Temperatures in cities like New Delhi reach 40 degrees Celsius (104 degrees Fahrenheit), and this invariably leads to massive imports of coal and the production of more thermal energy. …and in the end, what you notice in a country like India is that sometimes schools have to close for weeks, and offices have to be closed. There are times of the day when stations are not allowed to operate because at that point the consumption of air conditioning is too great for the economy. What I’m trying to say is, once you’re in a situation where something else is happening in the background like energy shortages or fuel price hikes, these climate shocks can exacerbate mitigation and adaptation strategies at that point in time.

More from Bloomberg Opinion:

• Yes, we can wait. But it won’t fix the drought: Amanda Little

Horrific droughts should be a global warning sign: Editorial

• California loves electric cars, but will still be stuck in hybrids: Liam Denning

This column does not necessarily reflect the opinion of the editorial staff or Bloomberg LP and its owners.

Jonathan Levine has worked as a journalist at Bloomberg in Latin America and the United States, covering finances, markets, and mergers and acquisitions. Most recently, he held the position of Head of the Company’s Miami office. He is a chartered CFA.

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