The proposition that carbon will be a game-changer for companies and investors was advocated by Paul Gilding and me in our recent paper titled Carbon-Induced Financial Disruption. In the course of discussions that followed, one of my colleagues asserted that markets would efficiently price in the possible impacts, therefore why would investors need to worry?

This is an interesting statement and worthy of examination. If the data from the recent Potsdam Institute study is so compelling, why haven’t markets already moved? You may recall that the study determined the “budgeted” amount of CO2 we can emit in order to keep warming within acceptable limits. To limit warming to 2°C, it implied that 75 per cent of fossil fuel reserves on company balance sheets could not be burnt and were, in theory, worthless.

The “efficient market hypothesis” states that, at any given time, prices fully reflect all available information on a particular security or market. Therefore, unless an investor is privy to insider information, they have no advantage in trying to out-predict the market.

Despite this theory, many investors believe that markets are not always efficient. After all, would Warren Buffett have been able to achieve his stellar investment performance if the assets he acquired were all perfectly priced? He is quoted as saying "I'd be a bum on the street with a tin cup if the markets were always efficient." Some behavioural economists assert that predictable human biases such as overconfidence and overreaction lead to errors in the processing of information and contribute to inefficiency.

We do not have to go too far back in history to find anecdotal support for episodes of market inefficiency. Prior to the recent financial crisis the credit rating agencies were assigning AAA ratings to securities that were undeserving. Seasoned market players knew that something awful was building – but this was balanced by others who had an opposing view or took much longer to arrive at the same conclusion.

So how does climate change fit into the market efficiency argument? The Potsdam Institute study puts a boundary on CO2 emissions and makes the link between emissions and the quantum of our fossil fuel reserves. This information, in its raw form, has not been widely integrated into valuation models by the financial research community. At first glance, the market does not seem to be very efficient in this regard.

The reasons behind this include:

1. Paradigm shift – The implications of the research are so confronting that it may be dismissed by many because it is so far removed from our state of thinking today. As a society, when we are faced with some form of crisis we often attempt to fine tune our existing systems, and only when this doesn’t work do we accept that a radically different system is required.

2. Awareness – There is a large amount of climate data, research and associated conversation. It is hard to be across everything. Even highly skilled analysts will struggle to be across all of the issues, therefore research providers and commentators play a role in finding and interpreting the facts. In the case of the Potsdam Institute analysis, it appeared in the journal Nature, which I suspect is not on the regular reading list of most (if any) financial analysts!

3. Dispersion of views – The Potsdam Institute analysis is the product of a robust scientific process and from that Paul and I drew our own conclusions about global policy action. There is no rule that requires everyone to agree with us. Last week, Citigroup Global Markets used the scenarios that Paul and I foreshadowed to see what impacts could flow through to company valuations. In their research, they made it clear it was for illustrative purposes, as they did not believe that we could achieve global coordination to limit warming to 2°C (which, in itself, is alarming).

For such a large and complex issue as climate change, we wouldn’t expect to see an instantaneous market reaction to one piece of new research in a scientific journal, as the information is somewhat distanced from the financial audience. Contrast this to an adverse earnings announcement by a company that instantaneously affects its share price – because the information is readily available and highly visible to all of the key players in the market. This type of information can be readily translated into valuation models, compared to the multi-faceted task of translating future carbon policy and market paths into valuations.

As investors hone their views about the implications of climate change there will be impacts felt in the market. The real questions for investors are: If they perceive there to be material risks and opportunities, how do they position themselves? What future scenarios are they considering and do they wish to proactively exploit inconsistencies between their ‘reasonable assumptions’ and market prices? Or do they prefer to take the extra risk and respond reactively?

If we accept that markets contain inefficiencies that, from time to time, become quite significant, then investors who have developed above-average processes for gathering and analysing information are well positioned to produce better quality returns.

With respect to climate change, on one hand we have a weight of genuine scientific evidence about the anthropogenic links to climate change, and on the other, there is a relatively low level of risk factored into the valuations of carbon-exposed companies. This may be better described as a tension between an underlying truth and the human biases inherent in the market.

As we saw with the recent financial crisis, the truth often prevails.

Phil Preston is the principal of Seacliff Consulting, a firm offering specialised consulting services in the financial and responsible investment fields. His prior work includes 17 years of financial research and portfolio management in the funds management industry.