A new report from KPMG in Canada finds that the mispricing of climate-related impacts could make it harder for companies and investors to manage climate risks, hinder efforts to transition to a low-carbon economy, and expose businesses and investors to the risk of a disruptive repricing.
The report, Do asset prices fully reflect climate risks and opportunities? examines empirical evidence on the pricing of climate risks by capital markets; explores the opinions of senior investment executives; investigates underlying policy, time horizon and data availability challenges; and highlights guidance available for companies and investors to address these challenges.
Complexity, uncertainty and data gaps facing investors and reporting issuers make it difficult for capital markets to adequately price climate risk
Uncertainties make it difficult for capital markets to adequately price climate risk
"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."
Moreover, there's also a tendency for investors to underestimate the risks of chronic climate risks such as rising sea levels since they may not fully materialize within traditional investment time-horizons. But this ignores both the accelerated frequency and severity of acute climate-related events and the high probability for these risks to be priced into the market by the time the holdings will be sold, adds Telem.
The report highlights that as the transition to a low carbon economy rapidly accelerates against a backdrop of increasingly severe climate-related events, the question as to whether markets are effectively pricing these risks is no longer academic. As noted recently by the Bank of Canada, the risk that commodity-exporting countries like Canada could fall behind in the global race to reduce carbon emissions could in turn have a material impact on gross domestic product (GDP) through lower foreign demand and declining prices for emissions-intensive commodities.
A recent KPMG International survey of CEOs, CIOs and senior investment strategists around the globe found that market players have varied opinions as to whether, and to what degree, the markets are adequately pricing risks and opportunities. In fact, only one in seven respondents believe public equity markets fully reflect climate risks. That drops to only one of ten for alternative investments and one of twelve for bond prices.
According to the survey respondents, the pricing of climate risks is being hindered by slow and only partially effective policy actions by governments and financial regulators; the capital markets' bias towards the short term; and the lack of standardized disclosures of corporate climate risk and performance.
Yet, despite challenges, most (72 per cent) survey respondents believe capital markets can or will start factoring climate risks at a notable scale over the next three years. While many are already working towards more effectively pricing climate risk within their organizations—with about half of the survey respondents noting that they have already adopted a mature approach to pricing climate risk across their active and passive portfolios—more than one-in-five are only now starting to raise awareness or assess options.
"Despite the wave of 'net zero emissions' commitments made in the lead-up to COP 26, there is often a lack of available consistent and reliable data on the climate risks and opportunities faced by companies," says Telem. "More data is also required on how these risks are being mitigated and on the carbon emission profiles of their broader 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."
While accounting and industry organizations are developing and adopting standardized approaches to guide companies in this area, businesses are increasingly reporting according to the widely accepted framework developed by the Task Force on Climate-related Financial Disclosures (TCFD). Recent guidance has been published by the Canadian A4S CFO Leadership Network to incorporate climate change risks and opportunities into business valuations. This could include potential adjustments to cash flows, terminal values and discount rates to reflect the impacts and uncertainties presented by both transition and physical risks to companies.
Another key opportunity for investors, the report notes, is the growing trend to invest in the transition of heavier-emitting companies and industries to move them from 'grey to green.' In addition to seeking financial returns from potentially underpriced sectors, these investments can have a significant positive impact on climate. The risk is that precluding 'grey' companies from accessing traditional sources of capital could further exacerbate climate issues by pushing companies to unregulated financing that won't require transparent disclosures and low-carbon commitments.
"It's important to recognize that governments, regulators and market participants all have a significant role to play to address these challenges," says Telem. "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."
About KPMG in Canada
KPMG LLP, a limited liability partnership, is a full-service Audit, Tax and Advisory firm owned and operated by Canadians. For over 150 years, our professionals have provided consulting, accounting, auditing, and tax services to Canadians, inspiring confidence, empowering change, and driving innovation. Guided by our core values of Integrity, Excellence, Courage, Together, For Better, KPMG employs more than 10,000 people in over 40 locations across Canada, serving private- and public-sector clients. KPMG is consistently ranked one of Canada's top employers and one of the best places to work in the country.
The firm is established under the laws of Ontario and is a member of KPMG's global organization of independent member firms affiliated with KPMG International, a private English company limited by guarantee. Each KPMG firm is a legally distinct and separate entity and describes itself as such. For more information, see home.kpmg/ca.
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