How a Climate Shock Can Befuddle Investors

A colleague once told Ryan Riordan that Wall Street traders will only care about climate change when Manhattan is under two feet of water.

In his latest study, Riordan, Distinguished Professor of Finance at Smith School of Business, takes this wry commentary seriously. He tests how traders behaved when Manhattan was indeed under two feet of water and they were unable to lay odds on the end result. With an unprecedented — and unpredictable — hurricane bearing down on a global city, did they continue buying and selling assets?

It’s a question that’s increasingly being asked as the investment community frets about how climate change will affect behaviour on trading floors. Riordan’s study suggests they are right to be worried.

Generally, weird weather events are great opportunities for investors to make a buck. Weather derivatives and weather futures, for example, are well-established financial instruments. But some types of meteorological mayhem offer little risk-related data. These confounding events present a level of unknown peril that can unnerve even the most hardened investor.

Risk Versus Uncertainty

At issue is the distinction between risk and uncertainty, one that may be lost on anyone but economists. Risk applies to situations where the outcome may be unknown but certain probabilities can be calculated. Flip a coin — you’ll win 50 percent of the time. Uncertainty applies to situations where there is insufficient information to even establish probabilities.

This is not splitting hairs. Firms in capital markets use sophisticated risk assessment models and analytics to leverage future events, imagined or anticipated. If they can assign a mathematical probability to a tornado or drought, they’re off to the races.

But faced with an uncertain situation that cannot be analyzed using conventional tools, what is an investor to do? In theory, sit on the cash or go to Vegas — anything but make a play in the market. That seems to have happened during the financial crisis of 2008. Normally during such “risk shocks”, trading volume rises as investors rush to buy or sell assets. In 2008, with financial systems under strain and policymakers confused, trading volume dropped dramatically.

“It’s always been difficult to test because uncertainty shocks are rare and often have no clear  beginning or end,” said Riordan during the Green Finance conference organized by the Institute of Intergovernmental Relations at Queen’s University and Smith School of Business. “The other problem is that uncertainty shocks also happen when we get risk shocks, so it’s really difficult to disentangle.”

Learning from Hurricane Sandy

Riordan and a group of German researchers had an inspired idea. Why not use the infamous Hurricane Sandy of 2012 as an uncertainty shock to finally show that true uncertainty had distinct effects on market trading?

Sandy was the largest Atlantic hurricane on record and one of the costliest in U.S. history. It was dubbed a superstorm for good reason: the last time a storm with similar characteristics hit New York City was 1821, when skyscrapers were the stuff of science fiction. But there were two big unknowns: what path would Sandy ultimately take and how intense would it be? As the storm swept through the Caribbean and rumbled up the Eastern Seaboard, there were new projections by the hour.

“This unprecedentedness made it very difficult to define a probability distribution of the potential damages,” said Riordan.

Among those anxious to assess the potential risks were investors interested in buying or selling shares in Real Estate Investment Trusts (REITs) holding property in the path of the storm. This offered Riordan and fellow researchers — Dominik Rehse (ZEW Mannheim) and Nico Rottke and Joachim Zietz (EBS Business School) — with an ideal natural experiment. They focused on the week prior to Hurricane Sandy’s landfall. They compared the performance of publicly-traded REITs that held properties in the evacuation zone of New York City with REIT stocks without properties in the unaffected areas.

The researchers focused on two key markers: trading volume and bid-ask spreads. The bid-ask spread is a bellwether of market liquidity; it’s essentially the difference between the highest price that a buyer is willing to pay for an asset and the lowest price that a seller is willing to accept. The wider spread, the less liquid the market.

“Environmental uncertainty is an indirect tax on asset prices and hinders market functioning”

When the researchers analyzed the data, their hunch was confirmed. First, they found statistically significant and economically large effects of uncertainty on trading volume. A REIT with a portfolio allocation of 10 percent in the evacuation zone of New York City had a 16 to 31 percent lower trading volume than a REIT without property in the evacuation zone.

“The decrease in trading represents lost gains from trade and implies that a large number of investors held portfolios that they may have preferred not to hold,” Riordan told the Green Finance delegates.

And second, the researchers found that during the uncertainty shock, the bid-ask spreads widened.

Ironically, as such “unprecedented” superstorms become more common in the future, economists and financial analysts will have more information to incorporate into their models. Uncertainty shocks will become risk shocks that markets will know how to deal with.

Accounting for Shadow Costs

But Riordan says the study has a message for those concerned about sustainable finance in the short- and medium-term. At  present, most models of the effects of climate change on markets and asset prices assume a direct cause and effect: floods or drought or gale-force winds damage infrastructure and economic assets. But what this study shows is that, even in the absence of physical damage, the unpredictability of climate change can lead to financial losses.

“Our model suggests a more nefarious relationship,” said Riordan. “Environmental uncertainty is an indirect tax on asset prices and hinders market functioning.”

These “shadow costs” can include underinvestment by firms and lost gains from trades that never happen. It makes risk sharing, which is one of the primary purposes of having a financial market, much less efficient.

Events such as Hurricane Sandy are pushing these shadow costs out into the open. It will help the financial industry get a lot more comfortable with uncertainty in a rapidly warming and unpredictable world.

—Alan Morantz