Portfolios, Greenwashing, Stress Testing, and Long Run Risk

Professor Robert F. Engle III, Nobel Laureate in Economics and Michael Armellino Professor of Management and Finance at New York University Stern School of Business, recently delivered a thought-provoking talk at Sasin titled “A Financial Approach to Climate Risk: Portfolios, Greenwashing, Stress Testing, and Long Run Risk,” on February 27, 2024. Professor Engle, also Co-Director of the Volatility and Risk Institute at NYU Stern Bridges, stressed that while the full effects of climate change may not be immediately apparent, asset prices today reflect forecasts of long-term cash flows and productivity, providing valuable insights into future risks. “Climate change is mostly about long-run risks. Even though we see lots of evidence of climate change damages today, the future damages are likely to be much worse,” he said, adding, “Although the climate science is proving to be pretty accurate, it does not tell us how, where or when the damages will occur or how big the economic costs will be.”

CLICK HERE TO VIEW THE RECORDED LIVE TALK ON FACEBOOK

Providing a more concrete picture, Professor Engle got the audience to imagine what they would do as the owner of a beachfront luxury hotel facing the risk of sea-level rise. Professor Engle explained how they must consider the long-run risk, including the physical risk of the sea level rise. Investors, on the other hand, should consider the termination risks, such as changes in the termination date and demand when making investment decisions. “In a stochastic world, changes in the termination date and changes in demand will be key factors in returns, and surely these will require a risk premium,” he said. Professor Engle said that when hotels face termination risk, they can consolidate and reduce the supply of hotel rooms to maximize monopoly profit, similar to practices observed in the energy sector. Companies may opt for consolidation, where one entity decides when to terminate operations and sell assets to another, aiming to achieve economies of scale. However, Professor Engle said that it’s important to note that consolidation doesn’t necessarily imply favorable conditions but rather a strategic approach to managing operations more effectively. Furthermore, Professor Engle discussed different ways Thailand may get to net zero by the year 2065, indicating four government policy approaches to mitigate climate risks. These include taxing carbon emissions, subsidizing renewable energy, emission regulations, and last, hope. He explained that while hope means having no policy, it’s based on hoping that the private sector will be sufficiently concerned about climate change and that eventually consumers, employees, investors, and corporations will voluntarily adopt greener behavior. One of the ways to ensure that green policies are adopted is to vote for politicians who are committed to implementing the necessary policies. “Policymakers have to decide what they are going to do about climate change, and if you think physics is predictable, policy is not…we don’t know what is going to happen, we have to form subjective measures of what policies are going to do in the future,” he said. Besides uncertainty about whether policies will be implemented to mitigate climate change, there is also the ambiguity of the intended and unintended consequences of such policies. Professor Engle said that countries heavily reliant on fossil energy industries are also exposed to termination risks due to decarbonization efforts. To mitigate the risks, these countries should adopt transition strategies such as diversifying their sources of revenue and developing new industries. This may involve investing in sectors like transportation, tourism, sports, and universities, thereby reducing their dependence on fossil fuels and increasing economic resilience. Professor Engle also urged consideration of transition risk, which arises when companies, especially in the fossil energy sector, producing significant greenhouse gases face pressure to cease operations, impacting them negatively amidst the rise of decarbonization efforts. He emphasized that policies aimed at mitigating climate change are designed to decarbonize the global economy, thereby introducing transition risks. To combat climate change, a question that must be asked is, “What is the public opinion like today, is the public going to vote for policies which impose transition risks on companies?” This leads us to another point: Professor Engle said that constructing a climate hedge portfolio is a natural strategy for investors aiming to reduce climate risk or those who believe the market underprices climate risk. Constructing such portfolios involves identifying stocks expected to perform well in a climate change environment, utilizing statistical information, and dynamically adjusting portfolios. These portfolios aim to overweight assets likely to thrive amid rising climate risks and underweight those expected to suffer. They can outperform the market if climate risk increases, with expected returns initially negative but positive repricing upon news of rising climate risk. These portfolios typically rely on firm characteristics or statistical criteria, with efforts to improve data disclosure. Professor Engle elaborated that climate hedge portfolios can be used for direct investment to attain climate hedge performance. Investors can also opt to invest in portfolios with a high beta on these funds to mimic similar performance. Additionally, they can detect greenwashing portfolios and assess climate factors in financial institutions like banks. According to Professor Engle, detecting greenwashing involves identifying instances where a portfolio is advertised as a climate hedge when it doesn’t actually fulfill that role. This can be done by regressing portfolios on conventional risk factors as well as climate hedges, which are derived from climate news. In essence, a green portfolio should exhibit a positive beta on a climate hedge factor. However, this process can be complex due to the presence of multiple factors and the inherent noise in beta measurements, making it challenging to ascertain straightforwardly. When considering termination risk for the planet, Professor Engle said that if the largest emitters commit to achieving net zero emissions by 2050, it will significantly reduce the contribution of smaller emitters to fuel emissions. This commitment can in turn incentivize technological advancements toward the same goal. Moreover, to mitigate transition risks for the planet, it’s imperative for the U.S., Europe, China, India, and other nations to reach agreements and cooperate on this endeavor, as demonstrated in the Paris Accord. “If the big emitting countries achieve their targets, the smaller countries will fall into line. But if we do not, then termination becomes increasingly likely,” stated Professor Engle. He concluded that if countries can achieve this collective commitment, it will be sufficient to avert the risks associated with such transitions. “When it looks like the future is really going to be horrible, we’ll decide we’ll do it,” he added.   Engle, Robert (2024, February/March). A Financial Approach to Climate Risk: Portfolios, Greenwashing, Stress Testing, and Long Run Risk [Presentation]. Presented at Bridges: Dialogues Toward a Culture of Peace