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Illustration of stormy financial situation
Climate risk should be a bigger factor in bond pricing, experts say. Photo by Ale+Ale

Location, Location, Location

Climate creates big bond risks, but markets are missing their moments

You're supposed to be able to trust "the market." Put your money in a government-insured CD and, with little risk, the interest rate will be relatively low. Invest in high-risk new technology – think Apple or Amazon – and returns can make you rich.

That’s how it’s supposed to work, anyway. But research by Erika Smull Ph.D.’22 and Martin Doyle, professor of river systems and science policy at the Nicholas School of the Environment, found a spot where the market seems to be misbehaving. More important in our current reality, where September 2023 was the hottest September on record and Antarctic sea ice set a record low, the misbehavior is the market failing to take into account climate change. Research showed this anomaly in the municipal bond market, a $4 trillion market where governments and agencies like utilities and school districts float bonds to pay for things they need. In a market like this, interest rates should be higher for riskier bonds – bonds from places facing higher climate risk. 

“If you invest in, say, John Deere,” Doyle says, “they’re all over the world.” Their various risks would not be especially linked to climate. “But investing in a municipal bond is great, because it’s a location: So we can say, is that location risky, yes or no?” 

Thus, you would expect long-term bonds from a place like Miami, facing climate-linked strengthening hurricanes and sea-level rise, to offer higher returns than those in places like, say, Omaha, facing less-severe climate issues. “What we were looking for on the risk side was a reallocation of capital away from some of these risky places,” says Doyle. But that’s not what they found. Despite the undeniable effects of climate change, “bond buyers are still treating cities with as wide a range of risk as Miami and Omaha the same.”

Companies flood your online searches with ads promising they’re saving the environment, and some markets – insurance companies changing their approach to coastal policies – are responding. Still, the market seems to miss a lot. And with climate change causing crises worldwide, the economy missing it raises profound questions. Duke is looking for answers.

“The running joke is that we hand freshmen a Goldman-Sachs tote bag as soon as they walk in the door,” Doyle says, laughing, but in fact, he says, Duke addresses climate economic issues from every perspective. “The combination of Fuqua, economics [in the Trinity graduate school], the Nicholas School, and the Kenan Institute of Ethics” means Duke is uniquely positioned to examine complex questions like how to get the economy to pay attention to things like climate risk.

Smull, the lead author of Doyle’s paper for the journal PLOS One, says that now that she works as a municipal credit analyst, she’s getting a sense of why the market misses climate. “It’s a whole pool of factors,” she says, involving things like rating agencies factoring in only default, not decline; a bond losing value because of climate problems doesn’t worry ratings agencies, as long as the city doesn’t default. And investors expect that in a true climate catastrophe, government agencies will bail out issuing cities, so again the bonds won’t fail. For that reason, municipal bonds get high ratings even for cities where climate risk is well known.

“I don’t think it will be fixed with more data and disclosure,” Smull says. People know about climate change, and the economy will respond to climate only when “a pretty large quantity of investors … make a decision to change.” 

Getting investors to make that change, says Doyle, starts with educating them. Part of the Duke Climate Commitment is the goal of making sure “every student at Duke gets exposure to it,” Doyle says. So, meet Diana Propper de Callejon ’84, who teaches Investing in Climate Solutions, a senior seminar, with Jason Scott ’90

“As one of our speakers likes to say, ‘Every job is a climate job these days,’” says Propper de Callejon, who, like Scott, flies to Duke once a week to teach the seminar. “You’ve got to know about climate because it is affecting every industry.” 

One point of the class is teaching ways to get the market to do in general what Smull and Doyle’s paper documented it failing to do: take climate into account. “One of the takeaways from our class,” she says, “is that a problem of this magnitude requires all hands on deck, all tools in the toolkit, and all levers that can be pulled. There's no silver bullet.” That means getting the economy to address climate includes both investment incentives, like the hundreds of billions of dollars of subsidies for alternative energy and transportation in the Inflation Reduction Act of 2022, and straightforward regulation. But “the important thing is that [government action] leverages private sector money.” 

Richard Mei, professor of the practice of natural resources finance, describes a way the market and the government are trying to work together. Mei runs the Natural Resources Finance Initiative, a Nicholas School of the Environment center working on sustainability and how it can address the climate crisis. “The discussion started like 50 years ago [with] how to monetize forest carbon,” long before floods in New York and terrifying heat waves. Now, he says, “maybe this is perfect timing.” Discussions moved along for years around various ways to adjust tree cycles and harvests to sequester more carbon. But change was always voluntary. Today, though, the Securities and Exchange Commission is preparing to “require that any public company should disclose their carbon footprint.” With growing awareness of climate issues, Mei expects that disclosure to affect stock price as investors begin to apply the environmental principles strengthened by continued coverage and discussion of temperature changes, devastating storms, and other climate catastrophes. “One of our goals is to train the next generation of talent in natural resource investments,” he says. “And we teach the unique characteristics of those renewable natural resources, and how to manage them, and how to finance those transactions.” 

Yet even with increased public awareness of climate issues and the best-intentioned government incentives and regulations, the market may simply overlook a more important issue.

Even describing the natural world in the language of resources "is already to have given the game away,” says Norman Wirzba, Gilbert T. Rowe Distinguished Professor of Christian theology and senior fellow at the Kenan Institute for Ethics. Wirzba was one of the lead instructors who created University 102, Let’s Talk About Climate Change, Duke’s universitywide course on climate, so he’s all in on the teaching aspect of waking the market up to climate. 

But “I do not think of my family as a set of natural resources,” he says. The market isn’t the problem; the problem is thinking of trees and carbon and even people as resources. “If we're prepared to say corporations can be persons, surely, we ought to be able to say that about other things that are clearly central to anything like a flourishing human life. These realities of streams, and forests, and soil, and butterflies, and deer and beavers. 

“They all are part of a moral community, in which we can register with each other as kin. And as kin, the way we relate to them now is going to be very different than if we related to them as an object that is to be instrumentally used.”

That’s a new approach, but as Doyle says, the old approach is a big part of the problem. “The mindset that markets are perfect is why we have so much climate risk,” he says. In a capitalist world, if you want change, people need to make money by making change. Doyle says that to understand how to embrace climate in finance you need to understand not just finance.

“The opportunities in climate for finance are so subtle that you can’t make money in it if you have a superficial understanding” of climate – or of finance.

“You actually need a pretty good understanding of both.”