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How Equity Markets have Priced Climate Transition Risks?

MSCI examines in its latest ESG study, the financial impact of climate transition risk on global equity markets and finds that climate has increased in importance in the last two years, with potential long-term implications for understanding market behavior.

Foundations of Climate Investing: How Equity Markets Have Priced Climate Transition Risks? To answer to this question, MSCI has used the traditional structure of risk model where it is assumed that any financial impact seen in markets is linked to a risk exposure and a risk driver. This structure leads to three subsets :

  • what type of financial impact in terms of earnings, stock price, valuation levels?
  • how to measure or approximate a company’s exposure to climate transition risk?
  • and what is driving the repricing of equities in the market?

MSCI has identified two types of economic drivers and transmission channels :

The first one is the climate policies which by targeting to reduce carbon emissions have a broader operational impact on companies, eventually materializes into the costs and earnings. In such case, the price of the stocks of the companies will therefore be impacted as well through the earnings channel. According to the research, the performance is higher for greener companies or less carbon-intensive companies than more carbon intensive ones.

The second economic driver is the flip side of climate policies, where green technologies and green R&D seems to lead to companies’ growth of earnings and revenue ; as such the low-carbon technologies and transition improve stock performance especially in the more carbon-intensive sectors like the utilities, materials, and energy.

To evaluate the potential financial impact of climate transition risk on companies’ earnings, the valuation levels, and its stock performance, the study compares the price-to- book level of two types of companies’ profile. On one side, the ones holding stranded assets and on the other side, the green ones; it show that valuation difference between companies holding less fossil fuel reserves with companies holding more fossil fuel reserves has increased over time.

“That means equity markets started to price a discount on companies holding fossil fuel. So basally equity markets become more and more pessimistic on the value of this potentially stranded assets.”

Guido Giese – Executive Director, MSCI Research

To translate this assumption into stock price impact, the MSCI team took company’s total emission profile, by aggregating the scopes 1 – 2 – 3 and imported this company’s emission profile into an effector model as a potential risk exposure. The outcome of the analysis reveals a positive cumulative factor return linked to company’s emission profile over time, which basically means that average greener companies tended to outperform over browner companies.

While this study clearly demonstrates that Low Carbon Transition has an effect on company pricing, it also emphasis on the fact that effects depend on the company’s profile, meaning that impact is stronger on the very carbon-intensive companies and at the opposite on the very green companies. Question for investors is to identify either this trend will broaden to all companies in equity market and if it will last over time.

Report can be ordered to MSCI here

Article: Joana Foglia – Source : MSCI

Post Author: Wealth Monaco