The effect of climate disasters on financial markets

First, the group (which also included Professor Martin Young in this project) looked at the appeal to investors of investment funds with an environmental focus. These have been steadily increasing in popularity as a general trend, and the research showed that after a climate disaster, popularity increases even more. ‘Environmental incidents bring the environment to the front of mind for investors,’ says Professor Marshall, ‘and they adjust where their investments are. The larger and more prominent the disaster, the bigger the effect on investments. In the US, for example, hurricanes are very prominent, and one that causes more damage is going to have a bigger impact than a lesser event.’

The research showed that this type of effect can be seen at a local level. ‘We know individuals are more likely to invest in companies close to home. We look at where managed funds are located, and then we look for disasters in the same state. That is more likely to be a memorable disaster for local investors than a disaster that happened on the other side of the country, for instance.’

A second piece of research looked at the effect of climate disasters on the stock market in general. ‘A principle of finance and portfolio diversification is that investing in different stocks that are moving in different ways at different times is a good way of spreading risk,’ says Professor Marshall. ‘But when there is a climate disaster, we found that many stocks start moving in a similar way. We think that is because at times like this, individuals are not as focused on their stocks, which then start trading less in line with what is going on in a company and more in line with what is happening in the market in general.’ This means that when a climate disaster occurs, diversification of investments is not as powerful as it usually is, and it is not as easy for investors to reduce risk in their portfolios.

In a third piece of work, the team looked at whether climate disasters influence the practice of insider trading, which occurs when directors and managers who have confidential information that other shareholders do not have access to trade company shares on the stock exchange. The results showed that insider trading increases significantly in locations that are experiencing climate disasters, and is even higher when the damage caused by disasters is larger.

There are several reasons why this might be the case. First, those in charge of companies are in a good position to predict the impact of a disaster on the firm more quickly and accurately than outside investors, meaning they can time their trades to earn larger returns than they would if the disaster information were fully reflected in share prices. Second, insiders may trade because the disaster impacts them personally. Third, managers may take advantage of the fact that investors will be less focused on their investments in climate disaster periods.

‘It’s possible that some managers and directors are looking for an opportunity to sell their shares when everybody else is distracted on something else,’ says Professor Marshall. ‘If other shareholders are worried about their house burning down, or being destroyed by a hurricane, managers can think it is a good time to sell.

‘The general theme here is there is clear evidence of climate disaster having a big impact on financial markets. It was interesting and surprising to us to find that the results are so strong. It has been known for a while that environmental issues affect financial markets, but we have picked out three areas of impact that hadn’t been known previously. Most of my research has focused on the US because there is a far richer data set to work from, but I don’t think there is any reason to think that a trend that is evident in the US would not be similar to a trend here in that investors tend to have similar characteristics in different markets.

‘I’m very motivated because it’s a real privilege to be able to work in an area that I feel is important. I think it is consistent with the ethos of Massey, which has a focus on sustainability. So it’s nice to be working in an area that is relevant to my discipline but it is also consistent with the broader Massey goal. I think at times finance has had a reputation as being very narrow with a focus on money and returns, but it is heartening to see that there is such an emphasis within the finance discipline on contributing to wellbeing more generally.’