3 questions to Riccardo Rebonato on the Climate Risk Premium

What Is a Risk Premium, and Why Is It Important?

The return investors can expect to make from a financial asset depends both on the (discounted) expected cashflows that the asset will generate, and on a compensation for the riskiness of these assets.

The important thing to understand is that this risk must be considered in the context not of the asset in isolation, but of the whole ‘market’ portfolio. So, a financial asset that pays well when the market suffers actually reduces overall risk, and therefore acts as a hedge. US Treasuries and German Bunds in the run-up to the COVID crisis are examples of assets that were perceived to provide a hedge to equity risk, and that therefore commended a negative risk premium. In these cases one can think of the risk premium as the ‘insurance premium’ an investor would be willing to pay. So, the key points are i) that the risk premium can make up a substantial part of the expected return of an asset and ii) that it can positive or negative.

What Is the Climate Risk Premium, then?

These days investors speak about ‘brown’ assets (i.e fossil-fuel-intensive assets) and ‘green’ assets (i.e low carbon-intensive assets) all the time, and what they generally mean by this are assets that will pay badly in state of high climate damages, and vice versa.

The next thing an investor would like to know is whether she will be compensated for bearing climate risk or whether, like for Treasuries in the post-Greenspan era, climate-exposed assets will carry a negative premium. At the moment we know very little about the magnitude an even the sign of the risk premium associated with green and brown assets.

Ultimately, it all boils down to estimating whether, say, the shares of oil companies will perform well when the market as a whole posts strong returns, or vice versa. For those firms whose payoffs are correlated with climate damages, the sign and magnitude of the risk premium depends on whether the climate damages occur when the economy goes well or poorly. We still know very little about this.

Why Using a Theoretical Approach to Estimate the Climate Risk Premium?

Estimates of risk premia are usually carried out empirically, by employing sophisticated econometric techniques that have been developed over decades. However, these techniques are very data hungry – many decades of relevant data are needed to obtain robust empirical estimates.

In the case of climate change, we just do not have this luxury, because investors have been paying attention to climate risk only in the last 10-15 years (which is “only yesterday”, in risk-premium-estimate studies). Indeed, those researchers who have tried to deploy the traditional tools to estimate empirically a climate risk premium have found results ‘all over the map’: contradictory, weak, and counterintuitive.

This is why, as we patiently wait to climate-relevant financial data to accumulate and for the empirical techniques to become usable, there is a pressing need from a first-principle investigation of what the climate risk premium should be (how large, of what sign, with what ‘term structure’). By a ‘first-principle investigation’ I mean an investigation that uses the most solid and state-of-the-art techniques in financial macroeconomics to provide robust and useable answers to a pressing investment question.

The EDHEC-Risk Climate Impact Institute has been set up to answer this type of questions. On the 29th of June I will discuss what the latest modelling tools can tell us about the climate risk premium, and what this means for investment professionals.