Mustafa Dah: Why Don't Markets Consistently Price Heat as a Tangible Risk?
Hello, and welcome to Enterprising Investor, the flagship investment podcast for the CFA Institute. I'm Kevin Max, editor of the Enterprising Investor blog, and I'm joined today by Mustafa Dah. Mustafa is an associate professor of finance and chair of the department of finance and accounting at the Lebanese American University in Beirut. He is an internationally published finance scholar whose research focuses primarily on corporate governance, including boards, executive decision making, investment efficiency, and corporate capital allocation. His broader interests include sustainable and climate finance, financial markets, and fintech.
Kevin Max:Today, as regions around the world are experiencing record high and prolonged temperatures, we're going to explore how heat is causing real world company level impacts and how that impact may not accurately be reflected in the market. Professor Dah wrote a piece for the CFA Institute on this topic. It's called heat is a risk. Markets still struggle to price it. And you can find it at cfainstitute.org under blogs.
Kevin Max:Mustafa, welcome.
Mustafa Dah:Hello, Kevin. Thanks for having me.
Kevin Max:Now you had already been researching climate finance and corporate governance when one heat related incident caught your eye. Tell us what that was and why it was a spark for you.
Mustafa Dah:Okay. So I had already been reading about climate finance for my research. My main area of research is corporate governance. So I was really interested in whether better governed companies are better prepared for heat risk and whether the investors take that into account when valuing these firms. So heat caught my attention because it's already affecting the financials, but the effects are still not really consistently and evenly reflected in the forecasts and valuations of the firm.
Mustafa Dah:And in in June, late June, there was the EDF case or, I think, which which was, you know, a very clear example, okay, of the issue. And we can I can elaborate a little bit about that if you would like me to do?
Kevin Max:Yeah. I think it would be great for our listeners to understand exactly what happened with power plants in France and with EDF.
Mustafa Dah:Okay. So what what happened is the river water, which was which is supposed to provide the cooling for for these plants, for these power plants, became too warm. So EDF had to reduce or even temporarily stop generation at several of these nuclear power plants. And that highlighted mainly a gap when we think about asset value because an asset can remain physically intact. Okay?
Mustafa Dah:But the operation or operational capacity of that asset, okay, will decline because it's in in such a case, it's depending on outside environmental conditions. And in this case, the company is really losing productive capacity at the time when the demand for electricity is at its highest because of the hot temperature. And what this means for investors is that now you have lower output, the revenue is gonna decrease, the operating costs are gonna increase, there might need to be operating and capital spending for adaptation. And, actually, this is what what EDF is is planning to do because they are planning an $8,700,000,000 in adaptation expenditures through 2040. So this is a was a very if you want, a very clear and perfect case of economic impairment without physical destruction.
Kevin Max:So heat, this natural thing, roam the rivers that were used to cool the nuclear plants that a lot of France's electrical utilities are based on, and that caused a real disruption to power. It caused a real disruption to operations and to the bottom line. Is that correct?
Mustafa Dah:Yes. That's perfectly correct.
Kevin Max:Okay. So let's define the problem a little bit. So why is heat as opposed to other climate related risks such as frequency and and intensity of hurricanes, frequency and intensity of wildfires? Why is heat trending right now?
Mustafa Dah:Because mainly because of visibility. Because, you know, a storm can can damage a building. Right? A flood can shut down a port. But when you look at heat, I think the main distinction is that the asset is still physically there.
Mustafa Dah:It's it's still intact. It's still working. But the but the operational capacity would decrease, and this will have a significant effect on the power, factory hours, outdoor work, okay, all of these things, and would increase also, you know, electricity and cooling costs. So nothing would be broken, but you are financially less sound or this is gonna be have a negative effect on your financials. And one thing that is that is very important here when we talk about heat and why it's really important right now, If it's something that is, you know, it's a one time thing, like one hot summer, I mean, then there's no reason to for this to enter into the future cash flow forecasts of the firm.
Mustafa Dah:But if this is recur recurring, okay, then this is not a temporary weather event. Now this becomes a business problem. Okay? Then this needs to be reflected in the financials of the firm.
Kevin Max:That segues nicely into this. So if heat is fundamentally different from many other that investors typically model such as, like, competition, supply chain vulnerability, and retaining key leadership, so why does heat not get that same scrutiny for modeling?
Mustafa Dah:Well, heat, it's it's it's it's it's different it's it's different things, I think. I think there are two gaps.
Kevin Max:Is it the physical nature being able to see that destruction and difference with, say, floods causing
Mustafa Dah:There is a disclosure. I think there is there is what we call the gap between, you know, the disclosures and valuation. Okay? And here, disclosure and pricing, they are two separate things. Okay?
Mustafa Dah:Because a company may disclose that extreme heat is affecting our operations and it's affecting our financials, but a lot of this would be qualitative. Okay? An analyst cannot put a general statement into evaluation model. The analyst would need much more information, okay, to be able to build the model. So the analyst would need, okay, which assets are exposed, how often the disruption is occurring, how is the output gonna be affected, how is the revenues gonna be affected, do you need the capital expenditures, adaptation expenditures, for example, all of these things.
Mustafa Dah:So this is, I think, one main gap in that sense. And another gap is inside the company itself because the climate information, a lot of time, sits with the sustainability team while, you know, forecasts, budget, capital spending sit with the financing financing finance team. And if these two sites are not connected, and in some companies, they're not connected enough, then the risk may be appearing in the annual report, but this is never being transferred to the financial numbers.
Kevin Max:So in another possible disconnection, so many investors might assume that heat risk is already reflected in valuations and that asset prices reflect all available information at any given time. So what's the evidence that this is not the case with respect to heat risk right now?
Mustafa Dah:Okay. There is actually I'm not gonna say it's not reflected because saying not reflected, I think this is a a strong statement. And I believe that it also, we can say it's inaccurate. Okay? But what I would say that it's it's partial.
Mustafa Dah:Prices are partially reflected, and it is uneven. So what happened, we have different research in that sense. One research, it's a working paper, suggests that actually investors are demanding a heat premium. So whether they are stockholders or bondholders, you can see this in wider bond spreads and higher stock expected returns for stockholders. However, this pricing is still partial and incomplete because there is also other evidence in research that is suggesting that analysts and investors are getting surprised by the effect of heat on the financials of the firm, and they're not reacting on this till after these financials or the financial figures are announced.
Mustafa Dah:There's a delayed reaction. So if there's a delayed reaction then this is not already incorporated in pricing. There's also other another research that suggests that a greater temperature sensitivity is leading to lower future risk adjusted returns. And these last two papers I'm talking about, they're published in Management Science, which is at the top journal in our field. So the claim is that it's not that they're never priced.
Mustafa Dah:The problem is that the adjustment is not always complete and consistent to be incorporated fully into the pricing.
Kevin Max:Right. Let's turn for a second to kind of sector and asset class in implications. Where do you see the biggest gap between actual heat exposure in the mark in market pricing?
Mustafa Dah:I think the biggest gap between heat exposure and is the reflection. Again, it's the reflection into being able to reflect that into the financial figures of the firm. And up until now, this is not happening the way it should be. One thing is that the analysis on the company level is not being the metrics used are not comparable. The information disclosed about the specifics and how heat is disrupting the operations of the firm is not complete.
Mustafa Dah:There's more information needs to be disclosed. And actually, need to and analysts need to request more information because if if they repeatedly and there's a repeatedly ask for it, at the end of the day, the the the company will have to disclose that and will have to provide this information.
Kevin Max:Right. So maybe there's a difference between what's happening at the sector level and what's happening at the company level. Are there sectors where investors should be paying closer attention to the role that heat is playing specifically?
Mustafa Dah:Yes. Definitely. I think sectors that depend on electricity, sectors that depend on water, outdoor work, electricity supply, these sectors definitely I mean, you you you you can they are more exposed to to the heat risk. For example, you have utilities. You have data centers.
Mustafa Dah:And some data centers not all of data centers, but some data centers are operating in hot regions because land and power, they're cheaper there. But at the same time, they're gonna get more exposed to to heat risk. You also have some usual suspects such as, you know, construction, agriculture, definitely. But as you said, there's and this is one of the the issues also in valuation. We have to differentiate between sector level analysis and company level analysis.
Mustafa Dah:The sector at the end of the day is only a starting point. But the real problem, okay, or the real question is how the company is operating. Okay? And how resilient the company is to heat exposure because there are different I mean, the sector has different companies, and these companies might have the different levels of resilience, adaptability, and all of these things. So the sector will tell you where to start looking, but the company level analysis, it kind of suggests how much risk the company is really exposed to.
Mustafa Dah:If you'd if if you'd like, I'd I'd also add one one more thing is that it's important to mention that some sectors here and some companies might benefit from that. Know? Because there are
Kevin Max:That's where I was actually going to ask you. It's not to put
Mustafa Dah:a happy face
Kevin Max:not to put a happy face on this situation, but where there might be opportunities with inefficient pricing and disparity between company and sector level disclosure.
Mustafa Dah:Okay. There are I'll answer this. I think there are two two two levels to this. First of all, there are some sectors and some some companies who would benefit because these are gonna be the companies providing the cooling systems, the grid equipment, energy storage, water management systems, and all of that. So the opportunity here comes from selling these products and services to the other companies.
Mustafa Dah:But for the other question, the discrepancy between the sector level and the company level. Okay. So sometimes this might lead to and it can go in in both directions. It can lead to mispricing. It can lead to some firms being overvalued while others being undervalued.
Mustafa Dah:So for example, if the disclosure is that, you know, we're just affected by risk, this is affecting our financials, but analysts and investors fail, okay, to channel the disclosed information into financial models and they're not reflected at all. This means that revenues are gonna be overstated, costs are gonna be understated, and as a result, flow is overstated, and the company will end up being overvalued. Other companies who are very resilient, they have spent a lot of money on adaptation. They are very or they are their sensitivity to heat exposure is very low, and let's say certain investors or certain analysts apply a uniform risk indicator for the for all of the companies in this in a certain sector or in a certain region, then they might undervalue this company because this company will not be affected like other companies. Because this company is resilient, they're not that sensitive to any heat risk or any heat wave.
Kevin Max:So for the savvy investor, there might be an arbitrage within a sector for different levels of disclosure and how that falls to the bottom line.
Mustafa Dah:Yes. So so, yes, so so the opportunity might might be really be in in the same sector itself. Okay? Because some sector some some come but you have to be able to conduct the analysis at the company level in order to differentiate between companies that are very sensitive to heat exposure and companies who are not that sensitive, companies that have adapted well and companies that haven't adapted well.
Kevin Max:Great. Well, now let's turn just 90 degrees and look at things from a portfolio manager's perspective. And from a portfolio manage manager's perspective, when does heat exposure become financial material to the portfolio?
Mustafa Dah:Okay. I I think it it will be financially material or can be considered financially material if it's large enough to change the company's financial numbers. Okay? And here, we can look at three things. First thing is, is it recurring?
Mustafa Dah:Okay? Is it a one time thing or is it, you know, it's it's recurring? We talked about this before. Second, is it can we identify a financial channel? Can we identify that it's affecting the financials of the firm?
Mustafa Dah:The third thing, if it's affecting the financials of the firm, is it large enough to move the numbers? Is it significant enough? So if the heat exposure is is repeating, it's affecting the company's financials and it's large enough to to really matter, then definitely it belongs in the financial model and not just, you know, it's it's not just be a climate disclosure.
Kevin Max:Great. And so when we look at that, do you look at specific indicators that portfolio managers should pay closer attention to?
Mustafa Dah:Yes. Definitely. I mean I mean, you need to look at certain, like, metrics. Okay? You have to look at, first of
Kevin Max:all I'm wondering
Mustafa Dah:be able
Kevin Max:to I'm wondering specifically if some of this can be hidden in insurance costs. If a company if company a is not really disclosing all of its financial risk related to heat, but it's spending more on insurance to protect against those risks, How does that look to an investor? How does that look to a portfolio manager? How does that look to you?
Mustafa Dah:Okay. But, you know, at the end of the day, insurance cost has has to affect cash flows. Right? So insure okay. So so the cash flows will will decrease.
Mustafa Dah:And one thing about heat is that, you know, standard insurance policies, it's hard for standard insurance policies to to cover heat because heat I mean, it's the same we we were back to the same thing. There's no physical destruction. Right? There isn't anything that is damaged, but just the production capacity or the operation capacity is decreasing. I think companies try to hedge this exposure to risk more through mainly weather derivatives sometimes.
Mustafa Dah:But this also has has a cost, and it's it's gonna affect the cash flows.
Kevin Max:Interesting. Okay. Professor Dah, I have one last closing question for you. And I know you've thought about this, but it's a good question. If you were presenting to the investment committee of a large global pension fund or sovereign wealth fund tomorrow, what's the one change you'd make to the way that they evaluate companies exposed to recurring extreme heat?
Mustafa Dah:Okay. I think the one change would be to make heat risk a routine part of the valuation model, not just something left to the ESG review or sustainability reports. This is especially important for long term, long horizon funds because they invest over very long periods. And, you know, this is something that would be recurring for many years to come, so it's gonna affect future cash flows. For every company with such a recurring and material exposure, I think the analyst should show where it enters the numbers.
Mustafa Dah:This is also very important, how it's going to affect the operations of the firm, how it's gonna affect, consequently, the financials of the firm, because that would help the investors identify the mispricing that we talked about in both directions, exposed companies that may be overvalued, and well adapted companies that may be undervalued. So when heat exposure, again, is is is is financially material, it should be treated as a long term financial risk, and it should be reflected in the financial models. Investors should not simply avoid every heat exposed company. I don't think this is the right thing to do. I think what they should do is they should identify which companies are better prepared and make sure that risk is reflected in the cash flow forecasts and the valuation models of the firm.
Kevin Max:And if you lead with this example from EDF, I'm sure more people will stand up and take notice that it's less about disclosure these days and more about actually modeling these these risks. Thank you so much for that was insightful, and I know our audience will take a lot of value from this. My guest today was Mustafa Dah, an associate professor of finance and chair of the department of finance and accounting at the Lebanese American University. And his scholarly article on this topic, Heat Is A Risk, Markets Still Struggle to Price It, is on our website at cfainstitute.org under blogs. Professor Dah, I thank you for your insight today.
Mustafa Dah:Thank you. Thank you, Kevin. Thank you for having me. Thank you very much. Appreciate it.
