How climate risk impacts discount rates—and what today’s investors should know

By BRG Managing Director Kenny Grant, Associate Director Jose Jimenez-Pereira and Managing Consultant Matthew Stein

Kenny Grant

In Berkshire Hathaway’s 2023 letter to shareholders, Warren Buffet highlighted that the company’s most “severe earnings disappointment” occurred in its electric utility business because the company “did not anticipate or even consider the adverse developments in regulatory returns” arising from climate risk.

Buffet is not alone in his reassessment of the impact of climate-related risk on asset returns. In 2020, for example, Barclays implemented an environmental, social, and governance (ESG) valuation framework. Other equity analysts have increasingly commented on the impact of tightening regulations around carbon emissions, fossil fuels, and other climate-related risks in determining asset values.

To consider these risks in discounted cash-flow valuation, we observe equity analysts adding premia to discount rates and/or applying haircuts to cash flows for assets perceived to have higher exposure to potential regulation to limit carbon emissions (e.g., nonrenewable energy companies). These adjustments aim to better align asset valuations with evolving regulatory and market realities, such as potential carbon taxes or other climate-related regulatory measures. We also note that economic transition presents opportunities for companies positioned to take advantage.

In this article, we explore mechanisms by which climate change may affect the discount rate within the Capital Asset Pricing Model framework. We conclude that climate risk over time may impact a company’s exposure to market risk, as measured by the beta coefficient, but that analysts should be cautious of making ad hoc adjustments to discount rates.

The Capital Asset Pricing Model

Jose Jimenez Pereira

The Capital Asset Pricing Model (CAPM) divides risks associated with assets’ return volatility into two categories: asset-specific risks and exposure to market-wide risks.

The CAPM is premised on the theory that risk-averse investors can mitigate asset-specific risks through diversification. Consequently, investors only price market risk. Assets with greater exposure to market risk are priced lower, all else equal.

The CAPM quantitatively measures an asset’s exposure to overall market risk using a metric called beta. Beta is equal to one when the relevant investment is as risky as the overall market, lower than one when the relevant investment is less risky than the overall market, and greater than one when the relevant investment is riskier than the overall market. For example, a beta of two would describe an investment that generally increases or declines by twice the observed change in the overall market. It means that we would expect its value to fall in price by 10 percent when the overall market falls by 5 percent.

In short, assets with higher betas are expected to carry greater market risk and thus bear higher discount rates in valuation models that produce lower asset values when those higher discount rates are applied to projected cash flows. Lower betas, on the other hand, indicate the asset is less risky to a diversified investor and lead to greater value, all else equal.

Climate change’s theoretical impact on betas

Matthew Stein

The systemic attributes of climate-related risk would, in theory, affect an asset’s beta to the extent that they increase or decrease that asset’s price along with the overall market. If climate-related risk factors increasingly impact the overall market portfolio, assets with greater exposure to these risks would tend to see their betas rise.

While literature on the potential impact of climate events on future economic activity continues to proliferate, one theory posits that the uncertain impact of climate change will give rise to what practitioners refer to as “fat tails”; that is, a greater-than-otherwise expected likelihood of extreme outcomes. Since extreme events can have outsized impacts on asset returns, and to the extent that investors continue to increase the degree to which they price these “tail risks,” it stands to reason that the market portfolio’s returns will be increasingly impacted by perceptions of climate-related risk.

Climate change’s impact on the practical application of beta

Ideally, beta should reflect investors’ current expectations of how asset returns will relate to future market changes. However, this is often difficult to determine in practice.

Investors frequently rely on historical data to estimate beta, effectively assuming that past market behavior provides a useful benchmark for future developments. Practitioners typically analyze historical correlations between an asset’s return and a global asset market index and consider questions around the duration of the historical period, return frequency, and whether to include comparable peer assets.

Factoring in climate-related risks presents additional challenges. As the market’s understanding of climate change evolves, the historical relationship between an asset’s return and the market may become outdated, making betas based on long or even short historical windows less indicative of present dynamics.

Consequently, practitioners face a choice: continue with the existing practical approach, based on historical correlations; or adjust the discount rate to account for potential changes in beta due to shifts that arise from new information.

How to account for climate-related risks

In a previous article, we advised against incorporating premiums into discount rate calculations that are unrelated to the components of the discount rate. This includes, for example, adding premiums for risks that can be diversified. However, in some cases, we anticipate that practitioners may choose to adjust betas in their discount rates to account for the contemporary significance of climate risks. This approach may not violate the theoretical principles of the CAPM.

Nevertheless, adjusting betas to account for climate risks poses significant trade-offs.

First, the extent to which an analyst would adjust an asset’s beta is subject to a degree of arbitrariness. In particular, how would an analyst precisely determine, based on recent trading data, the extent to which a beta appropriately captured an asset’s exposure to market risk?

Second, limited adjustments to the existing practical approach may suffice. For example, practitioners may carefully select their information window when considering climate risks by solely relying on trading data after a significant event or announcement takes place, such as the passing of important climate-related regulations.

In conclusion, as investors increasingly acknowledge climate-related risks, there is a growing need to reassess how we value assets. Weighing the advantages of integrating the latest developments against reliance on subjective judgments and limited data is critical.

The views and opinions expressed in this article are those of the authors and do not necessarily reflect the opinions, position, or policy of Berkeley Research Group, LLC or its other employees and affiliates.

(1)Barclays Equity Research, European Mining: ESG driving value differentials (November 2020).

(2)Ibid.