EDHEC-Risk Climate Impact Institute – Impact of climate change on global equity valuations

EDHEC-Risk Climate Impact Institute: The impact of climate change on global equity valuations – a novel approach

Climate change is not merely an environmental challenge but also an economic threat to global financial stability. A recent report by the EDHEC-Risk Climate Impact Institute provides a comprehensive analysis of climate-related risks to global equity valuations, emphasizing the need for integrating these risks into financial decision-making processes. This research highlights the financial vulnerabilities that both investors and policymakers must address in the context of climate change.

A probabilistic approach to climate risk

The report advances a probabilistic framework for assessing the impact of climate risk on equity valuations, offering a more profound understanding of economic outcomes associated with varying degrees of climate mitigation. 

By incorporating uncertainties related to both macroeconomic growth and climate-induced damages, the analysis suggests that, in the absence of enhanced abatement efforts, global equity valuations could decline by as much as 40%. This potential correction underscores the urgency for effective climate policy to mitigate financial risk. The potential scale of these losses serves as a stark warning to market participants who have yet to fully incorporate climate risks into their strategies.

The role of abatement policies

A central conclusion of the report is the significant role that abatement policies play in shaping equity valuations. The study demonstrates that a coordinated abatement strategy aligned with the 2 °C target of the Paris Agreement could limit equity losses to a range of 5-10%. 

Conversely, insufficient action on abatement could lead to much more severe financial repercussions, particularly if climate tipping points — thresholds that may induce abrupt and irreversible changes — are crossed. These tipping points, once exceeded, can lead to cascading effects that exacerbate economic instability, resulting in even greater reductions in asset values.

Probabilistic modelling vs. traditional approaches

The contribution of this research lies in its probabilistic approach, which models a broad spectrum of potential economic and climatic outcomes. Traditional valuation methodologies often rely on deterministic scenarios, failing to capture the complexities and uncertainties of climate risk. 

In contrast, the probabilistic model used in this study highlights the need to understand the dispersion of potential outcomes, underscoring that even without tipping points, equity losses remain a significant risk. The integration of probabilistic elements provides a richer, more nuanced view of future scenarios, allowing investors to better prepare for a range of possible outcomes rather than relying on a single projected path.

Physical damages and transition costs

The report also underscores the connection between physical damages from climate impacts and the transition costs associated with emission reduction strategies. Unlike traditional analyses that often treat these dimensions in isolation, this study employs an integrated framework that examines both aspects together. 

This integrated perspective is critical because physical damages and transition costs are inherently linked—effective mitigation reduces physical damages but comes with increased transition costs, and vice versa. The findings reveal that the most severe shocks to equity valuations occur under scenarios of minimal abatement, where physical damages cannot be discounted due to their impact on economic stability. 

These scenarios highlight the vulnerability of financial markets to climate inaction and the importance of proactive policy measures.

Implications for investors and policymakers

For investors and policymakers, the implications are unequivocal: climate risk must be embedded within strategic decision-making frameworks. Investors need to understand that climate risk is not a distant issue but a present and material threat to asset valuations. 

This report serves as a reminder that climate inaction poses both financial and environmental costs. The risk of significant corrections in equity valuations necessitates the adoption of strategies that prioritize sustainability, resilience, and proactive abatement measures to preserve long-term economic stability. These strategies should include incorporating climate risks into asset pricing models, stress-testing portfolios against climate scenarios, and engaging with companies to enhance their climate resilience.

Integrating climate risk into financial analysis

Integrating climate risk into financial analysis will require enhanced data, new modelling approaches, and a shift in investor mindset. This entails not only understanding the direct impact of physical climate risks on asset valuations, but also assessing the broader economic impacts that arise from systemic changes to the environment. 

Financial institutions must adopt advanced climate scenario analysis tools that can quantify the range of possible outcomes and help identify the most effective mitigation strategies. By doing so, they can ensure that their portfolios are better positioned to withstand climate-related shocks and capitalize on opportunities presented by the transition to a low-carbon economy.

Conclusion

The EDHEC-Risk Climate Impact Institute’s report serves as a critical warning for the financial sector regarding the risks posed by climate change. The projected decline in equity valuations without effective climate mitigation is a clear indicator of the economic consequences of inaction. 

As we navigate the interplay between climate dynamics and economic stability, integrating climate risk into financial valuation frameworks is essential for fostering resilience in the financial system. Now is the moment for policymakers, investors, and corporations to undertake meaningful action to protect environmental and economic interests. 

Failure to act decisively not only threatens asset values but also jeopardizes the broader economic stability upon which the global financial system depends. 

The time to act is now—through collaborative, informed, and sustained efforts, it is possible to mitigate the risks posed by climate change and build a more resilient financial future.

Sources

The report can be downloaded here.