Bayes hosts international conference on climate change, finance and monetary policy

Policy uncertainty is hampering the transition to a decarbonised world – and complicating life for investors – a Nobel Prize-winning economist warned at a major international conference hosted by Bayes Business School.

Professor Robert Engle talked about the role of hedge portfolios that take account of climate change-related risks. While those risks are usually long-term, they shape asset prices today.

He was addressing the New Environmental Challenges for Fiscal, Monetary and Macroprudential Policy conference organised by the Centre for Econometric Analysis at Bayes, the Rimini Centre for Economic Analysis, the European Central Bank and the Bank of England.

Hedge portfolios, which involve investment strategies designed to mitigate exposure to specific risks, would put a premium valuation on assets likely to benefit from a green transition and reduce or “short” assets facing high transition costs. Such portfolios, Professor Engle noted, gain in value when the likelihood of a green transition increases.

However, investors can only make informed decisions if they understand the dynamics around ‘green assets’ – many of which might benefit from moves to decarbonise – and ‘brown assets’ which face both regulatory and market pressures to adapt.

Pricing these risks can be challenging, Professor Engle said.

For instance, while hedge portfolios might seem less attractive in the short term, they often gain value when news emerges about worsening climate conditions, reflecting their role as insurance against adverse outcomes.

While some studies showed that companies with higher emissions earned higher returns, suggesting a risk premium for bearing transition risks, others suggested the opposite, with green stocks outperforming brown ones.

This discrepancy underscores the difficulty in defining and measuring ‘greenness’ and suggests we need to develop better metrics, he argued.

“Government policy can improve outcomes, research can help design better policies. A point that I think is really important is the collaboration between countries and researchers is essential to achieve these benefits. Investors and researchers must move beyond simplistic definitions of green and brown, recognising the nuances of emissions data, market dynamics and corporate strategies.”

Terminal decline?

Discussing the role of “termination risk”, he compared fossil fuel companies to a beachfront hotel doomed to eventual destruction by rising sea levels. The sector “exhibits many signs of termination risk”. Managers of such firms face tough choices: should they invest in maintenance and upgrades to ameliorate their emissions, or focus on extracting value before the inevitable decline? Investors, meanwhile, must weigh the risks of holding shares in such companies, balancing high current returns against the looming threat of obsolescence.

Declining market capitalisation, low price-to-earnings ratios, and high expected returns all point to a recognition that these businesses may not survive the transition to a green economy, he said. The industry’s focus on stock buybacks and dividends rather than long-term investments further reflects this mindset.

He set out four key approaches to decarbonisation: carbon taxes, subsidies for renewable energy, regulations on emissions and voluntary action (dubbed “hope”). Speaking days before Donald Trump returned to the White House, he noted that while carbon taxes and subsidies are arguably the most economically efficient, they also generate political heat.

Regulations and voluntary actions, though less effective, do play a role in shaping the market, he said.

Investors should embrace a portfolio-based approach to hedge against transition risks, he suggested, by creating separate portfolios for each decarbonisation strategy. These portfolios could help investors protect themselves from uncertainty and guide policymakers in understanding the market’s expectations.

However, even well-informed investors can be frustrated by a lack of clear guidance from governments on climate policy – and flip-flopping as administrations or priorities change.

He ended by returning to the question in the title he gave to his presentation: “Mirror, Mirror on the wall. Who’s the greenest of us all?”

“I don't know the answer to that. I've said some things which might be the right answer, but we’re still at the beginning of this problem, not the end of it. Governments have given investors a very hard problem which is not what we wanted with this transition. It would be very nice if governments could give us some forward guidance about which of these policies is really more likely to happen. If that were the case, then asset prices would adjust further in the same direction, and that gives lower cost of capital to green companies, higher cost of capital to brown companies.

“It really accelerates the transition. It would make everything happen more smoothly. The more confusing this is, the less effective it's going to be in terms of changing asset prices in a green direction.”

The return of President Trump, however, has “complicated this picture”.

Dr Elisabetta Pellini, a lecturer in Quantitative Methods and Econometrics at Bayes, said: “The conference was a success thanks to the contribution of excellent presentations from contributors and outstanding keynote speakers – including Professor Engle.”

Professor Giovanni Urga, Director of Bayes’ Centre for Econometric Analysis, said: “I wish to thank City St George’s and Bayes Business School for their support, which greatly contributed to the success of the conference. We are currently exploring exciting follow-ups with timely research opportunities and potential educational initiatives ahead.”