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Are markets pricing environmental risks?

As part of our research in collaboration with Verisk Maplecroft, we have been looking at how markets actually price in ESG risks – not how they should theoretically price them in.

The results point to an investment blind spot – environmental risk.

As shown in the chart below, the left-hand side summarises the relationship between overall E,S&G performance and spreads, investors tend to either ignore countries’ environmental performance or in some cases actively penalise better environmental performance.

Separate analysis of overall E,S&G performance shows major differences in impact

Source: Verisk Maplecroft, 2019

Looking at each ESG component separately – environment, social and governance – we also analysed the difference in spreads associated with a country being a low or medium performer, rather than a high performer, in each of the nine dimensions in our ESG scores.

We believe disaggregating ESG factors in this way is particularly important in relation to the ‘E’ factor, because of the likely mismatch between the time horizons of most investors and the timeframe in which a given environmental risk could materialise.

That mismatch of time horizons is implied in the way that markets ignore current environmental performance, encompassing factors such as water stress and air quality.

However, our results also show that investors actively penalise better performance in the future environmental dimension with higher spreads.

What could be driving these surprising results?

The future environmental performance clustering is largely driven by two predictor variables:

  1. Exposure to physical climate change risk
  2. Levels of terrestrial biodiversity

Those countries with the most exposure to physical climate change risk (which we categorised as low performers) also have the highest levels of biodiversity.

The regression analysis we conducted on climate change exposure and biodiversity individually shows that, all else being equal, investors price the debt of more climate change-exposed countries more cheaply.

When countries have similar levels of climate change exposure, investors then prefer countries with higher biodiversity.

This suggests that biodiversity weighs much more in the balance for markets than climate change exposure.

While investors are unlikely to be focused on biodiversity in literal terms, in a world experiencing environmental degradation in response to unsustainable economic pressures, it can act as a broad proxy for a country still having significant natural resources available for exploitation.

More broadly, the lack of incorporation of environmental factors by investors may reflect the challenge of managing ‘public goods’, which many environmental resources are, and so suffer from the ‘tragedy of the commons’. This is not helped by the many uncertainties regarding the impacts, which can be dispersed, have long latency or unclear scale.

But perhaps of more significant concern is the fact that markets appear to penalise environmental resilience, including environmental regulation and carbon policy, in all but the strongest economies.

Investors still prefer countries that have ineffective environmental regulations, manage water and waste poorly and which are not making an effort to decarbonise – except when their economies are robust enough to absorb the cost of high performance in these areas.

The bottom line

Our findings suggest that the growing focus of large institutional investors on environmental and climate risk has yet to translate into meaningful changes in market behaviour, at least in sovereign debt.

However, as our research only represents a snapshot of a few years, and climate action has only accelerated in the last few, we may start to see the situation alter. This could occur gradually, although it is also plausible that investors will eventually face an abrupt repricing of some environmental risks, especially those related to climate change, when either the risks themselves or market perceptions of their materiality cross a tipping point.

To read more on our research, download the full report.