Abstract

The paper evaluates whether biodiversity risk is priced in asset markets and breaks new ground in doing so. It concludes that biodiversity risk is priced and provides open-source metrics for measuring biodiversity risk based on media reporting and firm-level biodiversity risk exposure based on 10K reports. The paper's strength is that it uses primary data that is well-documented and offers it for further research. One important weakness is that both the statistical and economic significance of the result are not sufficiently discussed.

Summary Measures

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Overall assessment: We asked evaluators to rank this paper “heuristically” as a percentile “relative to all serious research in the same area that you have encountered in the last three years.” We requested they “consider all aspects of quality, credibility, importance to knowledge production, and importance to practice.”

Journal rank tier, normative rating (0-5): “On a ‘scale of journals’, what ‘quality of journal’ should this be published in? (See ranking tiers discussed here)” Note: 0= lowest/none, 5= highest/best”.

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Written report

Summary

The paper analyses how biodiversity risk is reflected in the stock market. It contributes to the early literature on the relationship between finance and biodiversity (Garel et al. 2023[1]; Flammer, Giroux, and Heal 2023)[2]. It finds that biodiversity risk is priced and provides open-source metrics for measuring biodiversity risk based on media reporting and firm-level biodiversity risk exposure based on 10K reports. In doing so, the paper addresses a new and important topic and facilitates further research on biodiversity risk in financial markets.

Following a methodology developed by some of the same authors in the context of climate finance (Engle et al. 2020)[3], the paper constructs a "biodiversity risk news index" that provides a time series of news about the level of biodiversity risk. The authors also develop several metrics of firm-level exposure to biodiversity risk by parsing 10-K reports. In addition, they collect survey responses from 664 academics, practitioners, and regulators to understand perceptions of biodiversity risk. Using these inputs, the authors construct a mimicking portfolio and document a positive correlation between changes in the tone of biodiversity news and the portfolio's returns. The authors benchmark their biodiversity risk hedging portfolio against other factors. The paper concludes that biodiversity risk is priced into equity markets, but market participants do not consider the pricing appropriate. An additional analysis of municipal bond portfolios concludes that the same risk is not priced in bond returns.

Evaluation

The paper’s main claim is that biodiversity risk is priced in equity markets. Specifically, the paper claims that news about biodiversity risk are correlated with returns of a portfolio sorted on biodiversity risk exposure.

The authors provide reasonable evidence for this claim. This is shown by constructing mimicking portfolios that are long (short) in industries with low (high) past exposure to biodiversity risk, according to an industry aggregation of the firm-level exposure measures created by the authors. Using this approach and a mimicking portfolio approach (which determines weights by regressing the series of innovations in the biodiversity news index on the series of firm-level excess returns), the authors find a

positive correlation of 10% to 20% between the portfolio returns and innovations in the news about biodiversity risk, using nine different variations of constructing the portfolios.

The authors do a good job of dismissing the concern that the measures of biodiversity risk capture other known firm characteristics by repeating the mimicking portfolio exercise with 207 characteristics (Chen and Zimmermann 2022)[4].

The authors are aware that they are testing a joint hypothesis, stating: “If biodiversity risk is priced in asset markets—and if our measures of exposure to this risk are correct—we would expect the price of these portfolios to move with the arrival of (aggregate) news about biodiversity risks.” Upon finding evidence of such comovement, the authors conclude that their measures are correct and that the risk is priced.

Two points limit the paper’s central claim. First, it is not clear whether the observed correlation is sufficient to accept the hypothesis. Second, the paper assumes that news about biodiversity risk reflects the true biodiversity risk.

Regarding correlation, the paper is not clear on whether a correlation of 10% to 20% is enough to conclude with confidence that biodiversity risks are priced. The confidence interval of these point estimates is not provided (see Figures 9 and 10, for example). There is also no discussion of the estimate's economic significance. Appendix A.4.3 reveals a p-value of one of the nine estimates (0.0462), but this information should be prominently disclosed in the main body of the paper.

The paper employs several measures, but the leading measure is based on news in the New York Times. It is not unreasonable to assume that the media reflects biodiversity risks. However, it is a critical assumption that is made, and the paper does not provide a sufficient discussion of this concern. The underlying biodiversity risk is potentially very large and slow-moving, as the paper points out in the introduction. It is conceivable that media-based indices capture changing levels of attention while the underlying risk remains unchanged. It is also the case that biodiversity risks can play out at very local scales, which means that a month-to-month change in national news coverage can be completely unrelated to dramatic local events, or that the news arrives when the risks on the ground have already materialized. It is important to be clear that the paper technically studies whether news about biodiversity risk is priced.

Further limitations that apply to the potential replication of the results is that the authors do not provide instructions on how the sample of firms is collected (Appendix A.4.5 describes how the sample of municipal bonds was collected, however). Furthermore, the paper does not report any of the results from the regression used to determine the mimicking portfolio weights (on page 30), which is an important step of the methodology.

Advancing Knowledge

The main academic contributions of the paper are to (1) introduce new firm-level measures of biodiversity risk exposure and an index of biodiversity-related news, and (2) show that biodiversity risk is priced in equity markets. The authors provide evidence that their new measures of biodiversity risk are not simply capturing previous measures of climate risk in equity markets. While the results suggest that some risk is being priced in equity markets (but not in municipal bond markets), the authors explicitly leave the question of whether the risk is adequately priced to future research.

The authors acknowledge that they do not differentiate between cash flow effects and investor preferences. When a New York Times article highlights deforestation, investor interest in deforestation is likely to rise, and investor favor for companies that engage in deforestation may decrease. This could lead to a decline in stock prices for these companies, resulting in lower returns in the short term, even if there are no changes in cash flow forecasts. In the current set-up, there is no way to differentiate between the shift of investor preferences or a change in future cash flows, which results in lower returns.

Real World Relevance

There are two reasons why this paper has real-world relevance. First, the authors provide the exposure measures and news index on their website (https://www.biodiversityrisk.org/). Investors are free to use this data to identify firms that use biodiversity-related words in their 10-K disclosures, for example. Second, the authors spend several pages (in section 2.3) explaining which specific risks the industries with the highest biodiversity risk are exposed to. Arguments are supplemented by snippets from firms’ 10-K disclosures. This analysis could be useful for practitioners who are trying to understand how biodiversity affects the business operations of certain industries.

The question of whether biodiversity risk is adequately priced is most relevant to the real world. The paper provides an indicative answer based on surveys, suggesting that the risk is not adequately priced. This is an initial step, but it is not yet a reliable answer because it is survey-based. Respondents may wish that biodiversity risks would be priced more because then market forces would help to limit biodiversity risks. Without an answer to this question, this paper offers a welcome first step but is by itself of little use to policymakers who are contemplating potential market interventions.

References

[1]Garel, Alexandre, Arthur Romec, Zacharias Sautner, and Alexander F. Wagner. 2023. “Do Investors Care About Biodiversity?” https://doi.org/10.2139/ssrn.4398110.

[2]Flammer, Caroline, Thomas Giroux, and Geoffrey M. Heal. 2023. “Biodiversity Finance.” SSRN Scholarly Paper. Rochester, NY. https://doi.org/10.2139/ssrn.4379451.

[3]Engle, Robert F, Stefano Giglio, Bryan Kelly, Heebum Lee, and Johannes Stroebel. 2020. “Hedging Climate Change News.” Edited by Andrew Karolyi. The Review of Financial Studies 33 (3): 1184–1216. https://doi.org/10.1093/rfs/hhz072.

[4]Chen, Andrew Y, and Tom Zimmermann. 2022. “Open Source Cross-Sectional Asset Pricing.” Critical Finance Review 27 (2): 207--264.

Evaluator details

1. How long have you been in this field?

   • More than 10 years.

2. How many proposals and papers have you evaluated?

   • About 50.