Reconsidering Climate Risk: A Return to Valuation Fundamentals

As evidenced by the recent release of the Security and Exchange Commission’s climate-related disclosure rule, climate risk has emerged as an important consideration in investment decision-making. Given that climate change is recognized as a risk that eludes diversification, much of the literature seeks to account for climate risk in valuation by applying a premium to the rate at which a firm’s expected cash flows are to be discounted. This approach, however, oversimplifies the issue and can result in misleading conclusions. The more robust—yet more challenging—approach entails a detailed analysis of the impact of specific climate risks on expected cash flows of the investment being valued.

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