Physical climate risks are being priced into cost of capital, finds analysis

Markets appear to be pricing physical climate risk into firms’ cost of capital, according to new analysis carried out by Bloomberg.

It found that companies with higher exposure to physical risks face a +22 basis point (bps) premium in their Weighted Average Cost of Capital (WACC).

The research looked at how the potential cost of repairing or replacing assets damaged by climate-related hazards affected how listed companies are priced.

The 10 hazards assessed included tropical cyclones, heat stress and flooding.

It found evidence that, after adjusting for structural factors, such physical risk exposure was associated with a positive change in WACC – specifically +22bps per +10 climate risk points.

“It is statistically significant (p-value <.001) and consistently positive across the 95% confidence interval (12-31 bps),” explained Niall Smith, a senior sustainable investments quantitative researcher at Bloomberg, in a blog about the findings.

He added that the results suggest “that capital markets are attuned to the fact that asset-intensive sectors with typically higher property, plant and equipment values are more exposed to the physical impacts of climate change, and are actively factoring this into risk premia”.

The pricing effect was found to be clearest within the materials and utilities sectors, which saw an average uplift of +56bps and +45bps WACC per +10 point increase in physical risk, respectively.

There was no notable country-specific sensitivity, although the most robust evidence was in emerging market regions of Latin America (+94bps) and Asia (+25bps).

“[T]hese results imply that markets may be pricing physical risk into financing costs, but that they’re not simply applying a straightforward ‘country risk premium’ to firm-level WACC,” Smith noted.

“Instead, the pricing signal appears across the global universe of firms rather than a simple country-average effect.”

Elsewhere, a study published in the Management Science journal this week claimed to show that issuers with a higher sensitivity to climate-related temperature rises were “consistently overvalued and deliver lower-than-expected returns”.

Using 50 years’ worth of US stock data, the researchers compared significant temperature shifts with firm-level stock performance.

They found that “companies whose performance is more affected by temperature changes are less profitable, pursue riskier business strategies and generate lower stock market returns than expected”.

“However, these same firms retained a high stock price, which suggests the financial impact of rising temperatures is being underestimated,” explained the University of Exeter, whose researchers were involved in the study, titled Temperature sensitivity, mispricing, and predictable returns.

Sell-side equity analysts were found to misjudge the impact of temperature.

“The researchers found that a trading strategy that bought stocks of low-sensitivity firms and shorted high-sensitivity ones generated an annualised, risk-adjusted return of 4.1% over the 52-year sample period,” Exeter said.

Local investors that were familiar with firms’ regional conditions were more likely to price in temperature-related risks than others, it added.

The sectors most sensitive to global temperature rises from climate change were agriculture and energy directly exposed to physical climate risks.

Earlier this month, the Network for Greening the Financial System (NGFS) published a paper exploring the state of physical climate risk data, which it said was essential to help investors manage their portfolio risk.

The influential central banking body concluded that financial institutions don’t have access to sufficient information about companies’ asset-level exposures, and highlighted a particularly significant gap in the level of visibility on insurance coverage.

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