Climate finance: What does the research say?

Climate change is one of the defining challenges of our time, potentially impacting the health and well-being of every person on the planet. It also poses a large aggregate risk to the financial system. Economic tools, designed for valuing and managing risky future outcomes, can therefore help society assess and respond to climate change risk.

While there is a large body of literature examining the interactions between climate change and the economy, many important aspects, such as the pricing and hedging of risks stemming from climate change, have received less attention.

In our article, Climate Finance, we review the literature on the role of climate risk in macro-finance models and the empirical analysis of climate risk effects on asset prices.

Climate risk in macro-finance models

There are two popular approaches to adding climate change-related uncertainty to economic models. The first emphasises climate change uncertainty as a direct source of economic risk. It thinks about climate risks in terms of a low-probability catastrophic event that could dramatically impact the economy: a climate disaster, often motivated by a tipping point, affects the future path of the economy since it directly impacts expected consumption growth.

In the second approach, climate change uncertainty stems primarily from uncertainty about the future of economic activity. The typical model embeds the following events: the economy experiences a growth shock, pollution increases alongside output, the increase in CO₂ emissions accelerates climate change, which in turn accelerates climate-related economic damage. In short, higher growth today is associated with larger negative effects on future growth through the climate feedback channel.

The two approaches have different implications for climate damage risk premia. When uncertainty emanates directly from climate disaster risk, climate damage tends to be unexpectedly high while consumption is low, because climate disasters drive reduced consumption. Assets that mitigate climate damages – those with high payoffs when climate damages are high – hedge investors’ marginal utility and thus tend to earn negative risk premia.

For example, consider an investment that reduces CO₂ emissions by one ton today, the value of which is often referred to as the social cost of carbon. In climate disaster models, this cost is relatively high, because payoffs to investments that mitigate climate damages are discounted at lower than risk-free rates.

Conversely, if the future of the economy creates uncertainty, it has the opposite impact on the climate risk premium. In these models, climate damages are larger when the economy is performing better. An investment that mitigates climate damages tends to pay off in times when consumption is high and marginal utility is low. In this case, mitigation investments carry positive risk premia, and the associated social cost of carbon is relatively low.

Empirical evidence on the pricing of climate risk

Investors and academics are increasingly exploring how climate risk is already reflected in asset prices. Climate risks can be divided into two types. Physical risks result directly from the effects of climate change on economic activity, such as impairment of property and equipment due to rising sea levels. Transition risks cover the effects on firms’ operations and business models that come from a possible transition to a low-carbon economy, such as a carbon tax leaving fossil fuel companies with stranded assets. When these risks occur, they will create winners and losers in asset markets. For example, while coal companies would likely suffer from the low-carbon transition, renewable energy companies might benefit.

Alok et al. (2020) show that fund managers adjust their portfolios in response to climatic disasters. Bolton & Kacperczyk (2020) analyse US equity markets and demonstrate that firms with higher carbon emissions trade at lower prices, all else being equal. Engle et al. (2020) document that stocks of firms with high environmental scores, which the authors argue are less exposed to regulatory climate risk, have higher returns during periods with negative news about the future of climate change.

How can investors mitigate the significant risks that climate change poses to their portfolios?

Engle et al. (2020) propose an approach to hedging climate risk that combines traditional dynamic trading arguments with novel statistical measurements using text analysis. They construct a climate news index based on The Wall Street Journal’s coverage of climate change. They systematically overweight stocks that rise in value when negative news materialises and underweight those that fall in value on the arrival of such news. In doing so, the hedged portfolio profits from adverse climate news.

A growing literature has started exploring the effects of climate change on real estate valuations, and correspondingly, on the mortgage market. This focus is hardly surprising. Hauer et al. (2016) estimates that a 1.8-meter sea-level rise by 2100 would affect about 13.1 million Americans, and Rao (2017) estimates that a six-foot sea-level rise would put 1.9 million homes, worth about US$882 billion, at risk of flooding.

Giglio et al. (2020) explore the pricing of rising sea level risks in coastal US states. They document substantial variation in climate risk exposure (e.g., differences in elevation) across properties in the same narrow geography. While properties in a flood zone generally trade at a premium compared to otherwise similar properties (likely because of positive amenities such as beach access), this premium significantly compresses when there is an elevated focus on climate risk.

Since most residential real estate is purchased with a mortgage, climate risk also affects these valuations. Consistent with this, recent research has shown that wildfires and flooding lead to increased mortgage default and affect banks’ securitisation decisions (Issler et al., 2019, Keenan & Bradt, 2020).

A research agenda in climate finance

Climate change will be a first-order issue facing our society for many years. Much progress has been made on modelling the relationship between climate change, the economy, and asset prices and on documenting how climate risk is already priced in financial markets. But much work remains to be done.

Computational advances will allow researchers to model the various feedback loops between climate change and the real economy with increasing sophistication. While the basic economic mechanisms of these models will be like those discussed in this review, such advances will provide new and improved quantifications of important objects such as the social cost of carbon.

Empirically, there is substantial scope for improving how climate risk exposures in different asset classes are measured. Improved firm-level disclosure and more creative use of alternative data (such as news text or satellite imagery) will be critical for this work. Improved data can also feed into much-needed research on how climate risk affects financial stability. It will allow financial institutions and investors to better assess their climate risks and will allow regulators to ensure that they do not threaten financial stability.

 Read our article Climate Finance here. 

 

 

 

This blog is written by academic guest contributors. Our goal is to contribute to the broader debate around topical issues and to help showcase research in support of our signatories and the wider community.

Please note that although you can expect to find some posts here that broadly accord with the PRI’s official views, the blog authors write in their individual capacity and there is no “house view”. Nor do the views and opinions expressed on this blog constitute financial or other professional advice.

If you have any questions, please contact us at [email protected]