New research led by New York University economist Viral Acharya attempts to measure the extent to which those costs are already reflected in the pricing of stocks, corporate debt and municipal bonds. The researchers found a significant impact from heat stress exposure on all three. I spoke with Acharya and one of his co-authors, Tuomas Tomunen, an assistant professor of finance at Boston College. A condensed and lightly edited transcript of the conversation follows. Their paper, which was co-written by Suresh Sundaresan of Columbia University and Timothy Johnson of the University of Illinois — can be found here.
Jonathan Levin: What were your key takeaways?
Viral Acharya: The first finding is that across markets the physical climate risk that seems to be priced — both statistically and economically significantly — is exposure to heat stress. Second, we find the economic magnitudes to be quite large when you standardize the distribution of physical climate risk across municipalities or corporations. About one standard deviation in variation seems to contribute, in the case of municipal bonds, something on the order of 15 to 20 basis points [per annum in muni bond yield spreads]. In the case of sub-investment grade corporate debt, something on the order of 40 basis points. And in terms of cost of capital in issuing equity, it’s also something on the order of 40 basis points per annum. While not earth-shattering, I would say these are still respectably large magnitudes that we’ve attached to physical climate risk.
JL: Has the market always perceived the additional risks from climate change?
VA: The pricing of the physical climate risks seems to be more consistent both economically and statistically — at least in the data and using our methodology — starting from around 2013-2015, depending on which test and which markets that we are looking at. There could be many reasons for this. One could be that heat stress risk has actually increased in the recent past, and so the manifestation of this risk in cash flows of municipalities and companies has led the market to price this risk.
JL: What about broader investor awareness of future risks?
VA: Maybe the risk was always there, but somehow with the activism of investors, multilateral agencies, think tanks, NGOs, etc., maybe there’s some learning and greater awareness of these risks in the markets. At any rate, the fact that these risks are priced more for sub-investment grade companies, the fact that they are priced more recently and the fact they are priced more for heat stress rather than risks like hurricanes or drought in which adaptation might be an easier possibility, we think that all of this gives us reasonable confidence that we are picking up what looks like a pricing of physical climate risk.
JL: Can you explain what investors might be thinking in demanding higher risk premiums for these securities?
VA: At the end of the day, our measures of physical climate risk are measures of expected losses for these companies. For example, at the county level, what would be the impact on productivity of employees in high-risk sectors such as construction and mining, where heat stresses would make it very hard for them to work? Even if there are some mitigation strategies such as air conditioning, those would add very significantly to your energy expenditure. Those are losses that would have to be incurred, and they will impact your cash flows.
JL: Walk us through how physical climate risk affects munis specifically.
VA: In the case of municipal debt, where we think that adaptation is not really feasible — you can’t change the location of the municipality — we think that it’s natural that the impact would be there. We did anticipate that munis would show pricing of physical climate risk. We find even in the case of munis that the effect is stronger for sub-investment grade debt, but interestingly it’s also stronger for longer-term debt because you expect climate risk to be sort of like disaster risk, which picks up in its accumulated frequency of arrival over a long period. And we also find that the pricing is stronger in revenue-only bonds rather than in general obligation bonds — general obligation bonds have a greater diversified pool of cash flows.
JL: What about companies?
VA: Companies can move their locations. They can move the intensity of their sales, employment and production at different plants. Yet what we find is that in the case of heat stress, in spite of the possibility of adaptation, especially for sub-investment grade debt, the effect of being exposed to heat stress is quite large. Now, we don’t find a similar effect from other physical climate risks such as being exposed to hurricanes, like being on the coastline, or being exposed to certain flooding and drought-style areas. We think that one rationale for this result could be that it’s not that hard to relocate your plants from being on the coastline to, say, a bit inside, whereas the gradient of heat-stress exposure moves very slowly geographically. There are just big pockets of states in one collection which are kind of all exposed to heat risk. Now you have to fundamentally shift your location altogether. Sometimes that could even mean changing your business model fundamentally. Like if you are an agricultural company in the Midwest, it’s not like you can just relocate to the Northeast, for example.
JL: And why do you think physical climate risk is more noticeably priced in riskier securities?
VA: There seems to be an impact on cash flows that then affects the probability of default risk. And where does it matter the most? It matters the most for companies which are already weakly rated to start.
JL: Can we just find a cheaper way of providing air conditioning or figure out how to cool and shade construction workers to keep them healthy and productive?
VA: The cheap way of providing air conditioning is also not that emission friendly. So the switch away from chlorofluorocarbons means that air conditioning also in some sense has become more expensive.
Tuomas Tomunen: Air conditioning is kind of like the one big way that humans are going to adapt to climate change, but the consequence of actually ramping up cooling is exactly what a lot of climate science literature thinks is ultimately the most expensive cost of climate change once you account for this type of adaptation. Of course, if we can find a renewable and inexhaustible source of energy, this problem would probably go away, but to the extent that we can’t, there doesn’t seem to be any easy solution to this type 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 get pretty interesting in a world in which power and fuel are also simultaneously experiencing very steep increases. For example, in an emerging market like India, where I’m from, every summer there is a very heavy load on power sharing in the country. Temperatures in cities like New Delhi reach 40 degrees Celsius (104 Fahrenheit), and invariably that leads to huge imports of coal and production of even more thermal power. … And ultimately what you observe in a country like India is that for weeks sometimes schools have to be closed, offices have to be closed. There are times of the day when plants are not allowed to operate because at that point the consumption of air conditioning is very, very large in the economy. What I’m trying to say is, once you’re in a situation where there’s something else going on in the background such as a power shortage or fuel prices are very high, these climate shocks can really exacerbate the mitigation and adaptation strategies at that point.
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Jonathan Levin has worked as a Bloomberg journalist in Latin America and the US, covering finance, markets and M&A. Most recently, he has served as the company’s Miami bureau chief. He is a CFA charterholder.
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