The next recession may be driven by an expected source

UC Davis study warns the markets to be prepared or face extreme correction

The next recession may be driven by an expected source
Steve Randall

What will be the source of the next recession? Leveraged loans? Credit card delinquencies? Coronavirus?

According to a study by the University of California, Davis, physical climate risk from extreme weather remains unaccounted for in financial markets and could cause an extreme correction.

"If the market doesn't do a better job of accounting for climate, we could have a recession -- the likes of which we've never seen before," said the article's author, Paul Griffin, an accounting professor at the UC Davis Graduate School of Management.

The study - "Energy Finance Must Account for Extreme Weather Risk" – was published this week in the journal Nature Energy.

It warns that there is too much “unpriced risk” in the energy market.

"Unpriced risk was the main cause of the Great Recession in 2007-2008," Griffin said. "Right now, energy companies shoulder much of that risk. The market needs to better assess risk and factor a risk of extreme weather into securities prices.”

He added that there is risk to the energy market from extreme weather, such as the unprecedented temperatures seen last summer in parts of North America and Europe.

If energy and other utilities are impacted by extreme weather, there is a likely effect on the wider economy too.

"Despite these obvious risks, investors and asset managers have been conspicuously slow to connect physical climate risk to company market valuations," Griffin said. "Loss of property is what grabs all the headlines, but how are businesses coping? Threats to businesses could disrupt the entire economic system."

Griffin also notes that, while energy market pricing already includes climate litigation risk, this may prove insufficient.

He also warns that investors may come to accept extreme weather impacts as normal and discount their future importance.