Blog Post

Resources Magazine: A Financial Approach to Environmental Risk

Dec 23, 2014 | RFF Staff

12-23 - RM financialWhen we talk about risk in the financial world, we are typically referring to an asset or portfolio whose price may decrease down the road. Even though risk implies a level of uncertainty, we are able to model and measure the risks associated with these assets. One of the typical ways we do this is to assess their volatility; if their prices change often, we would argue that you take on a large risk by holding them.

When volatility is especially low, it is very likely to rise again. But before the financial crisis, the risk management tools that we generally used did not offer an easy way to measure this potential and warn people in the financial sector that these risks could change.

Since then, we have built volatility models that allow us to project how fast risks can change, using historical data to simulate a number of future sample paths for long-run risks. These tools now allow us to look back on the period of time before the financial crisis to understand why everything went wrong when it seemed to be going well. In fact, just before the crisis began, only short-term volatility was low; in the long run it was high, significantly changing the situation’s perceived long-run risks.

Risks considered “long-term” are sufficiently far in the future that what we see today only has a tiny bearing on what the long-run risk really is and include events such as economic recessions, inflation, terrorism, war, and even climate change.

Climate Change as a Long-Term Risk

So why do we think of climate change in the long-run risk category? The scientific evidence is clear that the climate is changing. However, we are not sure what the economic costs associated with this change will be or what the economic benefits would be of doing something about it. The topic of climate change includes large uncertainties that we have to address as aspects of long-run risk, but the financial community is in the business of making decisions under uncertainty. Knowing this, how should this community approach climate uncertainties?

A good initial approach is to assess the potential financial impacts of climate change. We assume that the global economy will be able to produce fewer goods and services as climate change progresses than it would without climate change. We also assume that the government will have to take a number of actions, such as building dikes or moving power plants, and that funding these actions will require raising taxes and will increase the cost of doing business for companies. Costs from doing so may be significant, but they are far in the future and uncertain as of now. Revealing more information on these costs requires projecting and comparing a variety of long-run risk scenarios for the stocks or assets in question.

If you think about the whole of the market as being one large, risky asset that faces a long-run climate change risk, then we would expect today’s stock market to drop if future climate risks were seen as more severe. Conversely, we could expect today’s stock market to go up if future climate risks were thought to be less severe. Assuming these hold true, we wouldn’t have to wait 50 years or so to find out whether we’ve had a positive impact on the environment and would instead see the stock market respond today. If we are effective at responding to climate change, the stock market should reward us today for taking these steps to reduce long-term risk in the future.

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