Climate Risks And Market Efficiency
Harrison G. Hong
Princeton University – Department of Economics; National Bureau of Economic Research (NBER)
Frank Weikai Li
Hong Kong University of Science and Technology
Department of Finance, Guanghua School of Management, Peking University
May 7, 2016
We investigate the efficiency of the stock market with respect to risks brought on or exacerbated by climate change. We focus on drought, the most damaging natural disaster for crops and food-company cash flows. We show that prolonged drought in a country, measured by the Palmer Drought Severity Index (PDSI) from climate studies, forecasts poor stock returns for food companies in that country. A long-short portfolio of global food stocks based on PDSI generates a 9.4% annualized return. Our findings support regulatory concerns of markets under reacting to climate risks and calls for disclosing such corporate exposures.
Climate Risks And Market Efficiency – Introduction
We investigate the extent to which stock markets are efficient with respect to climate risks that are brought on or exacerbated by climate change. This question is important for at least three reasons. First, efficient capital markets can play an important role in helping households manage the risks of climate change. Such risks include a corporation’s exposure to carbon assets or inputs, which might be affected by future carbon prices or taxes. This so-called stranded asset issue has attracted the most discussion in regulatory and market circles at this point.1 But climate risks need not be so narrowly confined to carbon exposure. Vulnerability of corporations’ production processes to natural disasters such as prolonged drought, which is likely to be amplified by climate change (Trenberth, Dai, van der Schrier, Jones, Barichivich, Briffa, and Sheffield (2014)) and the focus of our paper, is also important and can impose significant damage to corporate profits. Regardless of the risks, to the extent stock markets can appropriately price the exposures of corporations, losses will be ameliorated by an appropriate risk premium.
Second, regulators worried about the effect of climate change on the stability of financial markets are proposing a variety of both voluntary and mandatory disclosure requirements for corporations regarding their climate risk exposures.2 Most notably, Mark Carney the head of the Bank of England has pointed toward the risks of climate change for financial stability and the role of disclosures (Carney (2015)). One impetus for this push is that markets might be underreacting to such risks because they might not be salient and disclosures can help the market better incorporate such concerns into pricing. A study of climate risks and market efficiency can hence characterize the nature of the potential inefficiencies, which might help shape regulatory responses.
Third, such efficient market studies, which would naturally focus on excess stock return predictability by climate risk variables, can be useful for practitioners interested in the construction of quantitative portfolio models to help manage such risks (Shiller (1994)). Climate risk variables can be quantified and have been used successfully in the pricing of weather derivatives.3 However, the broader question of the extent to which information on such risks is appropriately discounted in stock markets has not received much attention to date.
We tackle this broad question by focusing on the efficiency to which stock prices respond to information about drought. Our focus on drought has a few different motivations. To begin with, studies on climate change and crop production typically find that, among the natural disasters that might be amplified by climate change, including drought, heat waves, floods, cold spells, drought is considered one of the most devastating for economic production. A recent study (Lesk, Rowhani, and Ramankutty (2016)) looks at about 2,800 weather disasters along with data on 16 different cereals, including oats, barley, rye and maize, grown in 177 countries. They found that droughts cut a country’s crop production by ten percent, and heat waves by nine percent, but that floods and cold spells had no effects on agricultural production levels.
Our dependent variable of interest is the return of the FOOD industry portfolio from the Fama and French (1997) 17 industry classification, where FOOD combines food processing and agricultural companies. We focus on this aggregated industry portfolio as opposed to the finer industry classifications which separate FOOD into smaller components because drought is likely to have a direct impact on the profits of both food processing and agricultural companies. To begin with, a number of water engineering studies find that the food industry is arguably the most reliant on water and hence the most sensitive to drought risk (Blackhurst, Hendrickson, and Vidal (2010)).5 Moreover, there are increasing reports of dramatic short-falls in earnings and compressed profitability ratios or margins for even very large agribusinesses such as Cargill, Tyson Chicken, and Campbell Soup due to drought.6 For instance, Tyson Chicken, a large multinational food processor, suffered steep profit drops due to the 2012 droughts in the main US agricultural states, including California.7 Grain price is the main input cost for raising chickens. The higher grain prices squeezed the profit margins of even a large food processor. And extreme reductions of output can also hurt food businesses relying on turnover as well as margins. Drought also creates water shortages which impact agricultural companies. While some of these cost increases can be temporarily passed onto consumers or farmers might sell off some types of crops or livestocks, prolonged drought ultimately also severely impacts agriculture as well.
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