Are capital markets accurately pricing in climate risks?

New KPMG report suggests not, leaving investors lacking information about how to manage their portfolios

Are capital markets accurately pricing in climate risks?
Steve Randall

Few would have expected the cocktail of challenges that investors would be grappling with this year.

Putin’s invasion of Ukraine, the ongoing pandemic, and inflation are all on the agenda – and then there’s the ever-present risks posed by climate change.

On the latter, the management of the risks would be easier if data was more supportive, especially as this is leading to mispricing of climate-related impacts in capital markets.

A new report from KPMG in Canada updates its previous analysis of how capital markets are pricing in climate risk and asking whether calculations accurately reflect the risks and opportunities.

"While many investors, including Canada's leading companies, are making strides to effectively price climate risks and opportunities, the complexities, uncertainties and data gaps facing investors and reporting issuers pose challenges for capital markets," says Doron Telem, national leader, ESG with KPMG in Canada. "Currently, there is no generally accepted methodology for incorporating climate risks and opportunities into company valuations. Every investor does their own fundamental research or runs their own quantitative strategies."

Looking long term

Among the issues identified by the report, is that investors may only be looking at the risks for the traditional investment time horizon.

This means that they may underestimate the longer-term impact, which may be priced-in by the market later and affect their selling price.

The firm’s recent survey of CEOs, CIOs, and senior investment strategists worldwide, found that 7 in 10 do not believe public equity markets fully reflect climate risks, along with only one in ten for alternative investments and one in twelve for bond prices.

However, a similar share believes that capital markets can or will start factoring in climate risks at a notable scale within the next three years.

Adjusting portfolios

Around half of respondents said they have taken a mature approach to adopting climate risk across their active and passive portfolios and around 2 in 5 are raising awareness or assessing options.

But Telem says that despite net zero commitments made by companies, the lack of available data is still hampering efforts to mitigate risks and reduce the carbon emission profiles of their wider value chain.

"The demand on companies to fill these gaps and improve reporting is intensifying with investors, lenders, insurers, major customers and regulators all looking for more detailed information and analysis," he said.

With many Canadian businesses now reporting using the widely accepted framework developed by the Task Force on Climate-related Financial Disclosures (TCFD), there is greater clarity incoming.

But Telem says that there is an opportunity for investors in the move from ‘grey to green’ – the transition of heavy polluting industries to greener operations.

However, he notes that these transition industries need to retain access to traditional sources of capital, or they are likely to tap unregulated financing that does not offer the same level of reporting transparency.

"It's important to recognize that governments, regulators and market participants all have a significant role to play to address these challenges," he added. "Capital markets alone cannot effectively address climate risks and opportunities if existing government policies and securities legislation do not provide certainty to the regulatory environment and adequately incentivize the reallocation of capital towards a low-carbon economy."