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Current economic models don’t include climate models but that may not be the case for long. One Nobel Laureate shares his work on new climate models and how investment strategies may adapt to be optimized for impact, not just performance.

As the world continues to change, so too do our investment strategies. Whether it’s Environmental, Social, and Governance considerations, or ESG as it is commonly referred to, or Sustainable and Impact Investing, the value of our investments are no longer tied solely to returns. Contributing to social good, in areas including healthcare, education, and climate change are redefining our traditional measures of success and growth. Economists, central banks, and policymakers alike are exploring this new world of risks, and reward.

Nobel Laureate Robert Engle won the Nobel Prize in Economic Sciences in 2003 for his work on methods of analyzing economic time series with time-varying volatility. In a natural career progression, he’s now, among his other roles, the Co-Director of The Volatility and Risk Institute at Stern NYU. The Volatility and Risk Institute is an interdisciplinary center for research and analysis of both financial and non-financial risks. It focuses on newly emerging forms of risk including climate risk, geopolitical risk, cyber risk, financial risk, and more recently, pandemic risk.

“The Volatility and Risk Institute is very interested in whatever risks we think are going to face us now and in the future for financial investors and citizens alike,” says Engle. “Climate risk is one of the ones we’re very concerned about. It’s relatively new as a risk but has such enormous ramifications that we’re very worried about it.”

According to Engle, there are typically two forms of risks. The physical risks, including storms, droughts, hot weather and so forth. The second form of risk is transition risks, which are risks we take on ourselves when we try to reduce the impact of climate through measures like decarbonizing the economy.

“Transition risks turn out to be the ones we can model pretty well because they have sectoral implications,” says Engle. “Some companies and sectors are more exposed to transition risk than others, and so one of the things that we’ve done is develop a couple of factors which describe which kinds of asset prices are likely to be impacted by climate change.”

“One factor is based on the publicly available funds that Wall Street produces,” he continues. “They're based on different kinds of ESG measures. They're based on different ways of thinking about sustainability. And the question is which of these funds are the most useful for climate portfolios?”

The Volatility and Risk Institute then creates a portfolio of these funds by looking at which will have green characteristics in the sense that they will appreciate when there is new information about the climate and have positive returns.

“We think investors can decide how to put their money into climate action where they're trying to hedge the change in the climate that we all think is coming,” he says. “We look at this as a way of helping investors, but we also think of it as a way of helping regulators because we can do the same thing for banks.”

For Engle and his colleagues, collecting different datasets was the first and most important step. But it was largely work they had to start from scratch as climate-based data didn’t fit into any existing models. To properly measure and assess climate risk, they needed to build new frameworks and employ new analytical tools to identify which industries might be most impacted, and how this risk may trickle down to consumers and investors’ behavior.

“We have a lot of experience building models of economies,” says Engle. “Not one of those models has temperature in it. Not one of them has rainfall or precipitation or sea level or climate anything.”

While the physics and earth science can tell us about the aggregate behavior of the planet, it doesn’t allow economists to make accurate predictions. There aren’t any statistics either which means they have to rely on theory, making the theoretical framework of these risk models complicated.

“There is a lot of the gaps in the science and then the economics has to try to take the scientific predictions and figure out what would be the damages that we would expect,” he says. “One of the difficulties, of course, with doing this is that we're asking what's going to happen when something we've never seen happens. The econometrics of building a model based on these is very challenging.”

Based on their research, the Volatility and Risk Institute believes that the fossil fuel industries are going to be the most impacted as they remain the largest emitters of greenhouse gases. They don’t know, however, whether these industries will be adapting to more renewable energy sources, nor do they know whether the industry will pass on higher prices to customers or lower prices to their suppliers. Engle admits that because of these variables, the cost of climate change ranges substantially depending on which models you use and how you think about it.

“There is a lot of question about if you decarbonize, who is actually going to bear the brunt of that,” he says. “What has to happen is an adjustment of the way the economy works in all its different levels that are the most efficient use of resources. And this is one of the reasons why economists tend to like the idea of some kind of a tax on carbon, which lets the economy figure out what's the least expensive way of decarbonizing.”

Engle says that of course these climate models are not focused specifically on the financial sector because anyone who owns stock in a company has a vested interest in the future of that businesses, which is one of the reasons why some stock prices today are impacted.

“When you try to form a hedge portfolio, you might want to hold less of these companies that are exposed to climate risk and more of companies that are not exposed to climate risk or actually have some sort of a solution in their business model for climate risk,” says Engle. “And so a climate hedge would be a portfolio like that. In general, a hedge portfolio should actually cost you a little bit. However, if the climate becomes worse than the market expects and we think that it's not adequately priced in the market so far, then the companies that are prepared for climate change will appreciate in value and your hedge portfolio will go up.”

These new models and risk assessments can not only be interpreted by the stock markets and portfolio managers, but central banks can also adapt their strategies to better support green policies, linking climate change to monetary policies and help prevent future financial crises.

“Many central banks are concerned that if climate change is really happening, are the holdings that banks have, the loans they make, the assets they hold – are they going to be exposed to climate change?” says Engle. “The regulators would like to make sure that the banks that they regulate are not holding assets which will be severely impacted by climate change. We're all doing research to try to figure out what's the best way of assessing the vulnerability of banks to these kinds of risks.”

Engle hopes to see more movement from political engines to better deal with avoiding a potential crisis, as research and new models will only go so far.

“Plans are one thing,” he says. “Implementation is another.”