New research finds the economy could be plunged into recession — or a series of recessions — because financial markets don’t account for climate risk. Without a better knowledge of the risk posed by extreme weather events, the average investor can only hope that the next extreme event won’t trigger a sudden correction.
Paul Griffin, Distinguished Professor at the С Graduate School of Management, has been studying this ”unpriced risk” and how it can affect markets and the economy.
In this episode of The Backdrop, Griffin discusses the magnitude of climate risk, what companies and governments can do lessen the risk and how people can lower their financial exposure to it.
More information:
Extreme Weather Could Bring Next Recession
Global Consensus Needed to Develop Climate Risk Disclosures for Companies
Transcript
[00:00:00] Paul Griffin The typical economic recession comes around every 10, maybe 15 years or so. We're possibly in one right now. But with the future, when we look at climate shocks, we could be getting a recession every two or three years and the market may simply not be able to handle that.
[00:00:22] Soterios Johnson As if inflation, supply chain issues and the pandemic weren't putting enough strain on the economy and people's bank accounts, there is another factor more recently recognized as a possible cause of recession -- extreme weather. How big a risk is it? What can companies and governments do to mitigate it? And is there anything individuals can do to lessen their financial exposure to the risk? This is The Backdrop a С podcast exploring the world of ideas. I'm Soterios Johnson. Paul Griffin is distinguished professor at the С Graduate School of Management. He's a leading international authority in accounting, financial information and disclosures. And he's been studying the impact of extreme weather on company stock returns. Thanks for coming on to The Backdrop, Paul.
[00:01:04] Paul Griffin Thank you very much.
[00:01:06] Soterios Johnson So your studies have found that American companies are ignoring the risks of climate change and that could result in a devastating recession. What exactly did you study and how did you come to that conclusion?
[00:01:19] Paul Griffin Well, you're absolutely correct. Climate risk is very important to financial markets. And there's plenty of evidence, including my own, that the markets don't fully appreciate the seriousness or the severity of that risk. And as events occur over time, particularly events into the future, which could be more severe and more frequent, those risks are going to be have to be adjusted for by the markets. And if they're if they're unusual or unexpected, there could be a real shock to the market, which could drive the market way down into sort of bear territory, potentially causing shocks throughout the economy. And then potentially you can get a recession. Now, to the extent that you get recessions, they come around -- the typical economic recession comes around every 10 maybe 15 years or so. We're possibly in one right now. But with the future, when we look at climate shocks, we could be getting a recession every two or three years and the market may simply not be able to handle that. So, that's the risk that we face here and the risk that has yet to be fully addressed by financial regulators, by firms, by other of the folks that are part of the equation.
[00:02:41] Soterios Johnson Okay. So what are some of the risks that you identify and how do you quantify the risk?
[00:02:46] Paul Griffin Well, there are there are different kinds of risk with with the climate. This one is the sort of the pure environmental risk. And that's what you mentioned like earlier on the extreme weather. And these things are getting, again, more frequent, more severe. So that's sort of one kind of risk that's going on there. There's another risk in terms of this general concept of emissions that are being produced by firms, by organizations and so forth and are those emissions fully recognized by the financial markets? And there's plenty of evidence, again, not just my own, but others indicating that the emissions are not fully appreciated. So that's just another risk that's related to but not that separate from extreme weather and particularly in the area, what's called Scope 3 emissions. That's the emissions that you generate by driving your car, for example, or the emissions that are generated by getting goods to the market on the shipping, you know, cargo ships and so forth. Those emissions are almost unknown or completely, completely foreign to a lot of investment community. So that's so that's a second risk. That's the emissions risk is there's a third risk. And that is it's more like the transition to to net zero. It is how do we get rid of of or how do we deal with assets on the balance sheets that are sort of very carbon intensive? And how do we reprice those? That's the concept called "stranded asset risk" in the literature. So that's another risk. There's the liability risk. What, when are the floods, the floodgates are going to open in terms of allowing individuals, allowing other people, shareholders to sue firms for lack of understanding or lack of really protecting their investments through climate risk. So that's there's a litigation risk and there's a there's another risk, and that is will the policymakers get it rght? You know, hopefully they will, though, they'll institute the correct policy, but they could get it wrong. And in fact, so they could actually make matters worse before they make matters better. So there's a multitude of risks there. The sort of the the takeaway on all of that is that markets do not fully yet appreciate the totality of those risks. That's the issue I guess in a nutshell. .
[00:05:13] Soterios Johnson Right. And so I guess what you're doing is you're applying kind of a very established I don't know what actuarial science to this problem. And they're basically saying we just don't know what numbers to plug in, but the risk is there.
[00:05:28] Paul Griffin You know, we're using the best tools we have available in terms of research designs and econometrics and so forth. And the idea is to try to try to account for everything else that could be causing these outcomes, these these events, these consequences. And then and then relate whatever is left to things which relate to climate. So you might look at extreme events on a particular day and say, well, what's what's going on in the marketplace with respect to extreme events, allowing for everything else that could be happening in the marketplace. So essentially what we're doing is try to use the best tools available and to to set up designs designed to identify that particular effect and that what potentially is most likely cause of that effect.
[00:06:21] Soterios Johnson Mm hmm. Mm hmm. Are there certain sectors of the economy that are more vulnerable than others to climate risk?
[00:06:30] Paul Griffin Yes or no. It depends. It depends on the nature of the risk. Remember, I talked about the different kinds of risks that are available there. . So if you're in the energy sector and you've got a whole bunch of reserves, oil and gas reserves, you're going to be exposed to what's called the stranded asset risk because those those reserves could be worthless if if fossil fuels are essentially outlawed. So that's that would that would be affecting know sectors like the oil and gas and energy sector. But if you if you're in a even a large bank, a large financial institution, they could be exposed to all but whole different kinds of risk because they have a trillion dollar asset portfolio of loans to businesses. And those businesses are exposed to different kinds of risk. So the banks themselves would be exposed through, you know, through the risks to their loans that would relate to the risk to the bank. And, you know, you could be a firm located in a in a very climate vulnerable area. And so you could be exposed more so than other firms to extreme weather risk. So, it varies, you know, quite a bit depending on the risks are and also varies based on the the extent to which firms have taken steps, you know, to mitigate. Some firms do doing a better job than others, for example. So hopefully that's responsive to your question.
[00:07:53] Soterios Johnson Right. Right. Well, can you kind of give us a realistic example of how how this could go down? So let's say I don't know, you can just choose whatever sector you'd like to choose, whether it's, say, real estate along the coasts or, you know, oil companies or things like that.
[00:08:09] Paul Griffin Yeah. I mean, the one example that often comes up is, is the is the location of refining facilities on the Gulf. And of course, you've got these massive storms coming on the Gulf that could be getting worse over time. So you've got a lot of facilities exposed. And so can you move those facilities or can you harden those facilities relative to the the the hurricanes that come in on the Gulf, which, again, seem to be increasing in frequency intensity, so that that would be one. And two, just looking at our local situation here, we're subject to increasing numbers of wildfires and wildfire smoke and things like that. So those are risks that firms in the Western states have to take on. And the question is whether whether they would want to diversify away or harden their facilities relative to the increased wildfire risk that they're facing. Again, wildfire risk -- there's plenty of evidence that a good portion of that relates to climate change or climate change-related issues.
[00:09:18] Soterios Johnson And so I would think that companies would want to, you know, figure out what the risks are so they could plan for them. You're saying some companies are doing a better job of that than others?
[00:09:30] Paul Griffin Yes, that's correct.
[00:09:31] Soterios Johnson What is your solution to kind of help mitigate these risks as far as the market goes? I think you've been suggesting that there should be required disclosures, that companies have to disclose that kind of information to potential investors.
[00:09:48] Paul Griffin Yeah, I mean, there are a lot of channels that are sort of working to make people more aware of that, risk businesses more aware of the risk to take actions now to mitigate or to minimize. So you can think in terms of of transparency through disclosure, which is that point that you mentioned. And so there's a big effort right now at the SEC to require firms to disclose a lot about their emissions and about their carbon footprint. However, there's a backlash going on right now. And it's not clear to me whether the SEC will actually be successful later on the year and actually implementing it. If they do, the implementation could be delayed years to allow firms to get ready for the transition. So there's a disclosure side of it. There's the threat of the courts and the judicial system to, to, uh, I guess discipline firms or act as a potential, you know, sort of factor that firms have to consider when they do because of the threat of litigation. So that's another element of it. But the courts have been pretty slow. They tended to defer to the legislative process versus the courts. But that can change. There's plenty of lawsuits right now that are sort of working their way through the courts that that that could change. And then there's just the general habits of of consumers and people out there in terms of what they do and what they how they act in terms of buying carbon-intensive products versus not buying carbon-intensive products. So. So there's that. There's also the ability of governments, United States, elsewhere to tax emissions. Right? Put a carbon tax system in so that things that are emission-intensive are more expensive and therefore would drive the demand down. So a lot of differrent -- a lot of tools out there. One of the things that it does require is a coordinated effort across all of these tools. And it's not just coordinated at the country level, but it's got to be coordinated globally. And this this is a very tough problem, because you've got to get the global regulators together. Right? And you put them together in Paris, which they did a few years back. You might recall that. And everybody made promises to reduce their emissions. But those promises, there's plenty of evidence to suggest those promises haven't been kept. At least they're they're not being kept at the level perhaps they said they would they would a few years back. So lots of issues there. Tough, tough issues, actually, to to handle and to solve.
[00:12:22] Soterios Johnson Are there any other countries that are doing a better job of this on their own as opposed to what we're doing here in the U.S.?
[00:12:30] Paul Griffin Hard, hard really to know that because each country has in its interest to indicate that it's doing the best job possible, because it's becomes political in terms of the country. So we don't really know. And it's actually difficult to compare country A to B because we don't yet have what we call fully standardized metrics in each company's reporting system. It would not be quite the same. So it's actually difficult to put everybody in a horse race to see who's winning and he's losing.
[00:13:05] Soterios Johnson Mm hmm. So how does climate risk compare to other risks when it comes to causing a possible recession? I mean, is there a way to compare the risk, I guess, as far as when companies are weighing costs, benefits and how seriously to take this?
[00:13:23] Paul Griffin Well, I mean, if you go back to, you know, what we call the Great Recession of 2007 and 2008, I don't think regulators, policymakers, legislators, I don't think they were talking about, you know, that recession being related to climate risk. But since then, evidence is becoming more and more overwhelming and not just through the research that professors do, but through intergovernmental panels, for example. So that evidence is mounting. And so these risks in the next maybe not this current one that we potentially will have. But, over the next 10, 20 years, these these risks are going to be front-and-center of factors that are causative in those recessions or in those disruptions of the economy, which potentially could relate to and end up as a recession.
[00:14:22] Soterios Johnson I believe you published your first study on this in 2016, before the pandemic, before supply chain problems, before the war in Ukraine. So what have you learned since then to fine tune your conclusions? And do these recent disruptions make climate risk even riskier?
[00:14:40] Paul Griffin Well, just going back to some of the some of the first work I did as she goes back to about 2010-11 and there's there's essentially a sort of a lag in some of the publications. So sometimes the work will be done, but the publication lag could be several years. But looking at where we are today, yes, you have these unexpected events, you know, of the war in Ukraine and we have supply chain crisis and so forth. And those potentially will come up again, but hopefully not quite often. But what's not going to go away are the risk of climate change and what's not going to get any easier until, you know, there's concerted action globally, are these climate risks. And there's there's plenty of evidence that there's a lot of legislatures, a lot of country regulators essentially kicking the can down the road because you've got these competing interests. We'd like to deal with climate change now, but we've got a gasoline crisis. And so you've got that competing interests in terms of producing more gasoline to satisfy that demand. But that's going to increase emissions, not decrease, which is what what you need to do to address the climate crisis. So again, it's a really tricky issue, but yeah, the war will go away eventually, but climate change will not.
[00:16:13] Soterios Johnson So as we as a world stumble toward trying to solve the climate change problem, what can individuals do and individual investors or institutional investors do to minimize their exposure to climate risk until something can be done on a wider scale?
[00:16:35] Paul Griffin Well, it gets back to awareness and education and awareness of of the consequences of your action. You know, one thing I thought about and I don't I'm not sure why it hasn't yet occurred, but why doesn't everybody heaven have an app on their phone? And that app is simply recording their footprint, their carbon footprint on a day to day basis. So people are aware regularly as to what they're doing and what they what their actions are implying in terms of carbon. There's plenty of ways to do that in terms of measuring things, having a connection to satellite, for example, having a connection to your use of energy, you know, in the house or in the car and so forth. So there's things like that, which I think is a technology form of solution, but would certainly make people aware and awareness would lead to further knowledge and or deeper knowledge. And I think broader knowledge as well across the entire population, across the entire globe, if possible..
[00:17:41] Soterios Johnson You know, as far as requiring disclosures from companies about their carbon footprint and and other, you know, factors that go into risk, how likely do you think it is that anything like that will become a required part of their business?
[00:17:58] Paul Griffin Well, it it'll it will eventually happen. It will have to happen because otherwise the businesses won't survive. So survival eventually drive a solution. The issue becomes as to what the timing of that solution is. And so the the the longer the more delay in getting that solution in place, the more costly it will be. Yet some of those costs are not the costs that affect us on a day to day basis. They're longer term, and they're sort of more subject to maybe some some some subjectivity. So that's the issue, is that eventually it'll have to be dealt with. You know, we've we've got the survival at stake and particularly, you know, in countries that are less well-privileged than, say, the United States and elsewhere. So it has to be done. The issue is driving a solution a little bit faster than what we're looking at today in terms of the various governments all over the world trying to deal with it.
[00:19:02] Soterios Johnson I mean, it sounds like like it's the same quandary with climate change itself, that the crisis is coming, the crisis is here and it's coming. But we tend to not come up with a solution until after there have been very big, sometimes cataclysmic repercussions.
[00:19:21] Paul Griffin Well, I mean, but this, that and then there's all these things that get in the way, you know, like just go back to the earlier discussion the Ukraine war got in the way. Right? So we were potentially on a good a good pathway up until that point. And supply crisis, supply chain crisis got in the way. And so somehow or other, we need a sort of a period of relative relative stability with respect to other other types of things. And then the policy, the implementation of policy perhaps could go more smoothly with less less sort of, you know, diversions or turnarounds or offshoots and so forth.
[00:20:03] Soterios Johnson So before we go, what are you looking to study next? Are you looking to continue your work in this area as or any other kind of offshoot that you're looking to study more deeply?
[00:20:15] Paul Griffin Yeah. Several things going on right now. And most of this is sort of ongoing research. Publications could could be later on. But certainly the issue of what's called Scope 3 emissions is is hugely important. We need we need consistent, comparable measures. We need firms to be on board in terms of getting these carbon footprints done for their firms. What's interesting about this is the if you look at the private equity activity just in the past two years, it's about a billion dollars gone into private equity to deal with what's called carbon accounting solutions, like carbon footprints, firms and so forth. So some hopeful that some of that will pay off and firms will acquire ways to address these particular issues. So that's that's that's one thing. The second thing is really on the pace of innovation, which gets related to the P-E investment in in carbon solutions. So how is innovation going? How much innovation is in sort of green innovation? And and how successful is that or is that likely to be? And is it green innovation displacing some sort of more traditional innovation? So innovation is kind of lifeblood of an economy to a particularly capitalist economy. So keeping an eye on that is one thing I'm interested in. And potentially we will be looking at that in some detail.
[00:21:45] Soterios Johnson Right. And I guess when it comes to these companies, I would think that they really probably need to be prodded a little bit by government regulators, because a lot of these companies really are working quarter to quarter. They want their bottom lines to look good, even though maybe the long term picture should be looked at more more closely.
[00:22:05] Paul Griffin Well, I mean, that's true. I mean, there's a there's a sort of a short-termism bias in many forms of business. So we could we could extend that bias to firms presenting a longer term vision of where they hope to go. Certainly do that. But again, if you focus on the innovation, innovation as often, something that you do now and it could pay off you're for decades. And so to the extent that you can do that, it could bring about benefits of green innovation that provides a huge incentive to profit by way of helping the the economy become greener. So that would be a nice way to align incentives versus, you know, putting that aside and just focusing on next quarter earnings.
[00:22:52] Soterios Johnson How is your message being received by the private sector and by policymakers?
[00:22:59] Paul Griffin They're interested. There's sort of this slow. I think they're slower than some of us would like to to act. But they certainly are aware of these issues. They're aware of what what the research is. They are considering, you know, plans and strategies. But there's not the sort of groundswell yet of sort of momentum to to move large sectors of the economy. You're on the one side. You've got you've got the BlackRock folks that are pushing through the boardroom to get firms to be greener. But on the other side, you've got it's sort of an opposing movement right now that's gaining attention, saying going back to really the Milton Friedman line, you let businesses make profits and they'll make profits in the best way possible and they protect the environment. But you've got these two opposing trends right now. And and again, it could play out politically in the SEC proposal for climate disclosure for firms and also the new one that just came out, climate disclosure for mutual funds. So that's a new one that just came out a few weeks ago.
[00:24:15] Soterios Johnson And I guess you often hear this argument that, well, the market will figure it out, but that's what recessions are, right? The market figuring things out. But it can be a very painful thing for a lot of people.
[00:24:26] Paul Griffin Well, that's what we don't want. That's I think at the outset that's what that's what you indicated. I indicated we don't want. We don't want the market to learn in the most painful way. We'd rather have orderly transition rather than disruptive transition. And right now, to the extent we're not doing enough, the transition to to net zero, whatever it would be, 2050, the more likely to be a whole bunch of disruptions. We'll get there eventually. We have to, but we'd rather get there in a in a cost efficient way rather than a very messy way.
[00:25:00] Soterios Johnson Well, this has been really fascinating. Thank you so much for coming on to The Backdrop.
[00:25:04] Paul Griffin Thank you very much for having me.
[00:25:06] Soterios Johnson Paul Griffin is distinguished professor at the С Graduate School of Management. You can find more about his work on our website, ucdavis.edu/podcast. And if you like The Backdrop, check out our other С podcast Unfold. It breaks down complicated problems and unfolds curiosity-driven research like why songs get stuck in your head or what real world engineering concepts you can learn from comic books. Join public radio veteran and host Amy Quinton for Unfold. Subscribe wherever you get your podcasts. I'm Soterios Johnson and this is The Backdrop, a С podcast exploring the world of ideas.