W4: Lecture 8 Flashcards
"Climate Risk & Financial Implications" (18 cards)
Global negative externality
The basic foundations of a market-based economy are no longer effective.
One example of global negative externality:
–>GHG emissions
For a long time, GHG emissions were seen as a price to pay for economic progress and prosperity.
Emitters don’t bear the full social cost of their actions.
The Carbon Budget: What is it and why is it critical?
The carbon budget is the total amount of CO2 emissions the world can afford while still limiting global warming to a target level (e.g., 1.5◦C or 2◦C).
WHY critical:
It defines the finite limit we must stay within to avoid the most dangerous effects of climate change.
As of 2023, 2650 GtCO₂ have already been emitted, meaning that much of the budget has been used. Exceeding this limit would make meeting climate targets like those set in the Paris Agreement nearly impossible, and it increases the urgency for rapid decarbonization and transition planning.
The Paris Agreement of 2015
(COP21)
The agreement aims to limit global temperature rise to well below 2 °C and to pursue efforts to limit it to 1.5 °C.
New approach to global climate agreements: Intended Nationally Determined
Contributions (INDCs)
▶ Inclusiveness
▶ Bottom-up rather than top-down
Main Criticisms of COP 21:
▶ Cheap talk and lack of enforcement
▶ Pushing the hard policies into the distant future
Moritz Wiedemann (RSM) B3T2104
Main challenges to achieve climate goals
*pace of technological innovation
*political resistance
*coordination between countries
–>Investors must navigate these risks, as they will impact global economies and markets.
Two main financial risks related to climate change
- Physical risks
▶ Lower productivity in extremely high
temperatures
▶ Greater natural disaster risks
ex. wildfires - Transition risk
▶ Regulatory and technological risk
▶ Changing social norms
▶ Political risk: Mass migration caused by climate change
How do firms respond to physical risks?
Increases in temperature at supplier locations reduce the operating income of both suppliers and their customers.
Firms respond by:
▶ Terminating supplier relationships if heat exposure exceeds expectations.
▶ Increasing inventory or diversifying suppliers to mitigate risks.
–>Broader Implications: These disruptions highlight how firms already adapt their operations in response to physical risk.
What is transition risk? (name 2 dimensions)
Transition risk refers to the financial risks companies face as the world shifts toward a low-carbon economy. It arises from policy changes, technological innovation, and changing market expectations tied to climate action.
Two key dimensions are:
1. Cost of Transition
– How expensive or disruptive will it be for a firm to reduce its carbon emissions? Will these emissions decline fast enough?
- Investor Expectations
– How perceptions and preferences about carbon risk evolve, affecting firm valuations through risk premia or capital reallocation?
Transition Risk – Energy Demand
Transition risk from energy demand arises as the global economy shifts from fossil fuels to renewable energy sources. This shift affects companies differently depending on their exposure to energy markets and their ability to adapt.
Base Case (Stated Policies):
– Fossil fuel demand remains relatively high, aligned with current policies.
– Transition risk is moderate but climate goals are missed.
Pledge Scenario (Announced Commitments):
– Countries meet their stated decarbonization pledges.
– Significant decline in fossil fuel use, increasing pressure on high-emission firms.
Net Zero Scenario:
– A drastic cut in fossil fuel demand to nearly zero by 2050.
– Highest transition risk: firms must transform rapidly or face stranded assets.
Key takeaway:
The stricter the climate scenario, the greater the transition risk for firms reliant on fossil fuels, and the higher the value shift toward clean energy technologies.
Transition Risk – Technological Progress
Technological progress can rapidly disrupt carbon-intensive industries by making clean technologies cheaper and more scalable.
Key takeaways from the figure:
*Renewable energy costs are falling sharply.
*Electric vehicles (EVs) are becoming cost-competitive.
*Clean tech adoption accelerates the transition, increasing risk for firms that delay innovation.
Firms that fail to adapt face obsolescence, while early movers may gain a competitive edge.
Sources of Transition Risk
- Transition risk depends on:
▶ Technological progress
▶ Policy tightness
▶ Uncertainty about each element increases transition risk
(the cash-flow effect)
- Investors’ perceptions about carbon risk depend on:
▶ Evidence of climate change & socio-economic environment
▶ Stronger preferences for greening the economy amplify transition risk
(the discount rate effect)
Do investors care about financial risks related to climate change?
Yes, investors care more about transition risks relative to physical risks.
Measuring Transition Risk – Objective-Function Based Approach
This approach measures how far a firm is from achieving net-zero emissions, treating climate action as an optimization problem.
*Level of firms’ emissions (long-term risk measure)
–>Indicate the size of the transition needed
*Emission changes (short-term risk measure)
–> Track recent progress toward net zero
(+) Easy to apply
(+) Consistent with a well-defined objective function (net-zero target)
(-) Measures based on past emissions (role of disclosure)
(-) Forward-looking information is core of transition risk (role of commitments)
Measuring transition risk: Forward-looking text-based approach
This method uses textual analysis of company disclosures (like earnings calls) to assess climate-related transition risk.
*Measures how much firms talk about climate topics
*Distinguishes between regulatory risk and technological opportunity
*Reflects manager and analyst expectations about future transition exposure
(+) Captures information owned by managers and firm analysts
(+) Can be useful to isolate the climate impact resulting in future emission reduction (forward-looking)
(-) Not grounded in a clear economic framework
(-) Subject to potential greenwashing
(-) Computationally more intensive
Academic results of carbon premium
- Emission levels
*A positive and mostly statistically significant effect on future individual stock returns.
*Consistent with the idea that higher-emission firms are riskier. - Emission changes
*A positive and highly significant effect on future individual stock returns.
*Again, consistent with the idea that higher-emission firms are riskier and additional information is contained in emission changes - Emission intensity
*There is no statistically significant relationship between carbon intensity and stock returns.
Limitations of academic research on emission intensity results.
!!!A reduction in emission intensity does not mean a reduction in total emissions.
*Dividing emission levels by sales revenue introduces noise.
–>When emission intensity changes, it could be because of a change in sales revenue or a change in the level of emissions.
*With a noisier proxy for carbon transition risk exposure, it is to be expected that results are less significant
–> since sales were relatively stable in the research conducted
*A large firm can have a lower carbon intensity than a small firm, even though its climate impact in terms of the size of its carbon emissions is much larger
—> comparability issue?
The Tragedy of the Horizon: Climate Change and Financial Stability
Climate change has profound impacts on financial stability.
–> Losses from weather-related events have increased, and even more have increased the insurance losses.
“The Tragedy of Horizon”
Climate change risk is often neglected due to the long-term nature of the problem.
It goes beyond:
▶ the business cycle
▶ the political cycle
▶ the horizon of technocratic authorities, like central banks, who are bound by their mandates
So, investors and financial systems must address these risks, despite their long-term horizon.
Investor response: divest or engage
Reasons for divestment:
*Send a clear signal and apply public pressure on high-emission companies
*Reduce exposure to carbon risk in portfolios
*Support the moral stance against fossil fuel financing
*Can trigger reputational and market impacts when announcements go viral (e.g., Ireland Strategic Investment Fund)
Reasons for engagement:
*If other investors will still buy the security, sold, there is no reason to divest.
*Maintain voting rights and influence through shareholder proposals
*Proven to be a more effective way to induce change (e.g., CALPERS/CALSTRS position)
*Encourages companies to improve transparency and climate commitments
*Seen as a long-term risk management strategy
Shareholder proposals have become an important form of engagement
BUT
Divestment has become a mainstream way to respond to climate change–> “voice through divestment”
Issue of future divestment
!! Risk of exit from the portfolio if the stocks do not decarbonise (for NZ portfolios that have a decarbonising trajectory)
Firms with high distance-to-exit (DTE) scores face lower expected returns and valuation penalties (higher valuation ratios).
→ Future divestment acts as a “stick” to incentivize climate action.
