by Dr Mehrshad Motahari, Research Associate, Cambridge Centre for Finance and Cambridge Endowment for Research in Finance
The risk of climate change and its potentially drastic consequences has reshaped many industries in recent years. The financial industry has been no exception to this trend. Laurence D. Fink, the founder and chief executive of BlackRock, announced last year that his firm will make environmental sustainability a core decision-making objective and that he believes environmental awareness will soon lead to a ‘fundamental reshaping of finance’ (Times, 2020). This global concern about climate change has also brought about a new strand of literature in finance looking at the effects of climate change in financial markets (Hong et al., 2020). This blog post provides a brief summary of some of the key findings of this literature, together with their implications regarding the financial industry.
Barnett et al. (2020) provide one of the major recent studies, giving theoretical insights into the role of climate change in finance. They draw on continuous time decision theory to estimate the social cost of carbon. Under this framework, asset prices reflect the environmental damage of carbon emissions due to the uncertainty regarding the future effects of climate change on human welfare. The empirical evidence supports this and establishes that there is a risk premium associated with long-run climate change risk (Engle et al., 2020). A firm’s exposure to this risk factor is determined by their greenhouse gas emissions, among other measures of environmental friendliness.
In a recent study, Bolton and Kacperczyk (2021) explore the climate risk premium globally by looking at the distribution of corporate carbon emissions across 77 countries. Carbon emission in this setting captures the exposure to the risk associated with transitioning from fossil fuels to renewable energy. They find that companies with higher carbon emissions generate higher stock returns in most areas of the world, except for Africa, Australia, and South America. This positive premium is higher in countries with lower GDP per capita, less democratic systems, less developed healthcare systems, and those whose economic output relies more on their manufacturing sector. Also, they show that this carbon premium has risen significantly after the Paris agreement, which led to a rise in investor awareness.
However, it is not clear whether climate risks are priced correctly. Several studies show that investors do not pay attention to climate change risks and underreact to long-term climate trends (Hong et al, 2019; Krueger et al, 2020; Painter, 2020). Consequently, salient climate events (such as abnormally hot days) attract investors’ attentions to the problem, leading to firms with high carbon emissions underperforming compared to those with low emissions (Choi et al, 2020).
The characteristics of investors who hold the stock can also determine how climate change risks are priced. For example, Alok et al (2020) show that fund managers based in regions with frequent climate disasters overreact to negative climate events and underweight stocks affected by climate disasters more heavily. Therefore, stocks facing high climate disaster risks are more likely to be under-priced when they are held by such fund managers.
The climate finance literature also highlights several important implications for the financial industry and, in particular, asset managers. Focardi and Fabozzi (2020) argue that the process of transitioning low carbon emissions will have costs as well as opportunities for asset managers. On the one hand, climate change will introduce various new sources of risk, including climate regulatory and compliance risk, physical damage to assets and companies, and adverse social and economic impacts. On the other hand, Focardi and Fabozzi (2020) argue that portfolios and indices can be constructed in a way that would have low carbon footprints without penalising returns.
Overall, the recent findings show that the financial industry is headed in the right direction when it comes to climate awareness and action. The new costs and hurdles in the way of investors also have not led to their disengagement in the markets. Krueger et al. (2020) conducted a survey of investors and found that they generally consider risk management and engagement to be the better approach for addressing climate risks than divestment. Probably the most important remaining question is whether the financial sector can do even more to tackle climate change and, if so, how.
References
Alok, S., Kumar, N. and Wermers, R. (2020) “Do fund managers misestimate climatic disaster risk?” The Review of Financial Studies 33(3): 1146-1183
Barnett, M., Brock, W. and Hansen, L.P. (2020) “Pricing uncertainty induced by climate change.” The Review of Financial Studies, 33(3): 1024-1066
Bolton, P. and Kacperczyk, M. (2021) Global pricing of carbon-transition risk. Technical report, National Bureau of Economic Research.
Choi, D., Gao, Z. and Jiang, W. (2020) “Attention to global warming.” The Review of Financial Studies, 33(3): 1112-1145
Engle, R.F., Giglio, S., Kelly, B., Lee, H. and Stroebel, J. (2020) “Hedging climate change news.” The Review of Financial Studies, 33(3): 1184-1216
Focardi, S.M. and Fabozzi, F.J. (2020) “Climate change and asset management.” The Journal of Portfolio Management, 46(3): 95-107
Hong, H., Li, F.W. and Xu, J. (2019) “Climate risks and market efficiency.” Journal of Econometrics, 208(1): 265-281 (Special issue on Financial Engineering and Risk Management)
Hong, H., Karolyi, G.A. and Scheinkman, J.A. (2020) “Climate finance.” The Review of Financial Studies, 33(3): 1011-1023
Krueger, P., Sautner, Z. and Starks, L.T. (2020) “The importance of climate risks for institutional investors.” The Review of Financial Studies, 33(3): 1067-1111
Painter, M. (2020) “An inconvenient cost: the effects of climate change on municipal bonds.” Journal of Financial Economics, 135(2): 468-482
Times, N. (2020) “BlackRock CEO Larry Fink: climate crisis will reshape finance.” New York Times