When Hurricane Sandy hit New York City in 2012, it forced the closure of the city’s stock exchange for two days, the longest weather-related shutdown of the institution since a blizzard in 1888. A 30-member team slept at its headquarters, working tirelessly to bring the exchange back to life, even as the surrounding financial district was still flooded. The storm demonstrated the challenges posed to financial markets by climate change. Now, Ryan Riordan, a professor at the Smith School of Business at Queen’s University, has used the experience to study how to prepare for inevitable future climate shocks.
The extreme weather events associated with a warming planet can cause instability in financial markets, stemming from everything from flooded servers to disrupted supply chains. But the success of the markets rests on their ability to understand and respond to risk. What happens when they confront events where the concept of risk, as most people understand it, doesn't even apply? That's one of the biggest challenges posed by global warming. Researchers are increasingly suggesting these weather events don't fall into the category of risks, but rather, the more problematic area known as uncertainty.
From an economic perspective, risk applies where the outcome of a situation is unknown, but there is sufficient data to build a probability model for various outcomes. Flip a coin, and there's a 50/50 shot you'll guess right. That's the type of risk that financial markets are built to handle. Typically, there's a historical precedent. Even relatively complex events, like floods and droughts, have occurred often enough for economists to build reliable probability models.
In an uncertain situation, there's not enough information to establish probabilities. Not only is the outcome unknown, but there's no reliable way to weigh possible outcomes. And when you can't put odds on an outcome, investors tend to get nervous. That's exactly what markets face in the age of climate change, according to Riordan.
“We’ve never observed the climate changing like this, and we’ve certainly never observed an economy during such a situation,” he says. “No one can credibly predict what’s going to happen with climate change. We’re flipping a coin, and it’s weighted somehow, but we don’t know how it’s weighted.”
Riordan used Hurricane Sandy as a proxy for studying how uncertainty affects behaviour on trading floors. Risks associated with a hurricane can normally be evaluated, but Sandy was different. A hurricane of that magnitude hadn't touched down in New York City since 1821—that is, before Wall Street was Wall Street. Since there has been no equivalent storm, any changes in the markets would be treated as uncertainties, rather than risks, says Riordan.
“If something risky happens, and it's a negative event, you'll see a one-time adjustment in the market. There's a blip down in the trend line, a blip up, and away things go,” he says. “But uncertainty causes the whole trend line to flatten.”
To conduct his research, Riordan focused on a sector likely affected by Hurricane Sandy—real estate. The researchers compared the performance of publicly traded real estate investment trusts (REITs) with properties inside New York’s evacuation zone against those with no assets in the storm’s path. A REIT with just one-tenth of its portfolio in the zone saw 16% to 31% lower trading volume than one with no assets in the area. “What we find in our paper is the effects of uncertainty cause trading to slow, liquidity to get worse, and prices to depreciate just as a result of anticipation of something that traders can’t predict,” says Riordan.
One of Riordan's findings is that a climate shock creates financial losses beyond those caused by physical damage. And those losses are difficult to tally. You can assess the cost of damaged buildings and equipment. But it's difficult to know how many trades simply didn't happen because investors couldn't adequately assess the risk.
Some researchers consider these challenges in terms of acute versus chronic risk. In the context of climate change, acute risk refers to weather events like hurricanes, floods and so on. Chronic risks—like rising sea levels, increasing temperatures and melting polar ice caps—might cause more weather events. But they can also present a unique set of challenges that can't be accurately assessed, since they have no historical precedent. “We have a lot of empirical research when it comes to certain acute events, because we've experienced them,” says Emanuele Campiglio, an assistant professor at the Vienna University of Economics and Business who leads research efforts in climate economics and finance. “But chronic risk is still treated very speculatively.”
There are steps that individual traders could take to adjust to this new, uncertain world. One option is shifting portfolios toward low-carbon companies. “There will be winners and losers in a changing climate. Tilting your portfolio toward firms that are contributing to positive changes, or supporting the fight against climate change, I think will do better in the long term than firms that are contributing to it,” he says.
But addressing the larger issue will not prove easy. Climate change creates risk and uncertainty, but so will any effort to avert it. Proposals to “decarbonize” the economy create a new set of variables. “We've had paradigm shifts in finance before, but nothing close to decarbonization. That creates issues for financial investors, because the outcomes are hard to grasp,” Campiglio says. Decarbonizing the global economy also means a host of transitional risks—that is, those associated with restructuring—for both companies and the financial system as a whole. Some companies will have to completely reinvent themselves, while others cease to exist altogether. “It's very difficult to attach a distribution of probability to these scenarios,” says Campiglio. If that's true, and Riordan is right about the economy-dampening effects of uncertainty, financial markets are in for a serious shakedown as the climate crisis worsens.
Campiglio says policy makers will likely need to take the lead on addressing climate change, since financial institutions remain beholden to economic models. “We have financial institutions that are willing to act, but they have certain limits to what they can do,” he says, adding that the techniques used to assess risk might never catch up with the threat posed by a shifting climate. “There may never be a moment when we have an agreed-upon risk-assessment methodology in which we can say with certainty that green assets are less risky than brown. But the point is that we want to avoid climate change, so we need to act anyway.”