(Bloomberg) -- Bond markets may be facing sudden price shocks due to a failure to correctly take into account the risks associated with the climate transition, according to the Bank of England.
When looking at high-yield bonds with a maturity greater than eight years, the market is only pricing around 50% of the increased default probability expected from a so-called orderly transition scenario across most corporate sectors, the BOE said in its Financial Stability Report on Friday. The mispricing is even more pronounced when taking into account the possibility of a disorderly transition, it said.
Some sectors would be more exposed to losses than others, with longer-dated bonds particularly at risk, the BOE said. In the energy sector, for example, investors are currently pricing in less than 35% of the estimated risk that exists under an orderly transition scenario, according to BOE staff.
“This implies significant potential asset price corrections if investors were to start fully pricing in these potential impacts,” the BOE said. “Sudden movements in asset prices could in turn affect the resilience of systemic firms exposed to those assets or crystalize a number of existing vulnerabilities in market-based finance.”
Transition risks connected to the adjustment toward a net-zero economy may arise from developments in climate policy, disruptive new technology, impacts on supply chains for transition-related materials and shifting investor sentiment, the BOE said in its report.
Financing the transition toward a low-carbon economy has been identified by firms including BlackRock Inc. and Apollo Global Management Inc. as a huge investment opportunity. At the same time, strict regulatory definitions remain vague, making it difficult for companies and their investors to identify and price the risks they face.
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