Equity investors must face the "daunting" task of pricing the physical risk associated with climate change in order to shield portfolios from a looming shock to global financial stability and asset prices.
The International Monetary Fund (IMF) warned in a report published earlier this month that the physical risk to assets posed by climate change is not currently reflected in equity prices, meaning any "sudden shift in investors' perception" of this future risk "could lead to a drop in asset values, generating a ripple effect on investor portfolios and financial institutions' balance sheets".
It said that in addition to measures to mitigate and adapt to climate change, and actions to enhance insurance penetration and strengthen sovereign financial health, better measurement and disclosure of "exposures to climatic disasters" are needed to "facilitate the pricing of climate change-related physical risks".
However, the IMF accepted this was a "daunting" challenge for equity investors.
Commenting on the paper, head of UK equities at Mirabaud Asset Management David Kneale said: "The investment industry has barely begun to think about the enormously complex challenge of identifying, understanding and pricing physical risk."
In order to change this, Kneale explained it would require "accurate, regionally specific climate modelling, with precise timings of impacts", within a "far more complex discipline of modelling the real world environmental impacts of climate change".
Explaining ESG outperformance
Throughout the market turbulence seen so far in 2020, largely as a result of the coronavirus pandemic, so-called "ESG" stocks appear to have outperformed with the MSCI World ESG Leaders index - which measures the performance of the top ESG performers - up 2% year-to-date compared to the MSCI World's return of 1.2% year-to-date, according to FE fundinfo.
Kneale said the apparent outperformance of ESG stocks reflects companies "particularly well placed for traditional risks", such as those reducing or substituting high emissions activities, or have high levels of disclosure and "good behaviours" with regard to emissions.
He added: "I have seen very few businesses meaningfully address the physical risks that they face over the long term.
"Over time, I would hope that the investment industry becomes more sophisticated in its analysis of long-term physical risk. As this happens, capital will flow out of businesses which are not managing their exposure to climate risk."