Abstract
Climate finance is the study of local and global financing of public and private investment that seeks to support mitigation of and adaptation to climate change. In 2017, the Review of Financial Studies launched a competition among scholars to develop research proposals on the topic with the goal of publishing this special volume. We describe the competition, how the nine projects featured in this volume came to be published, and frame their findings within what we view as a broader climate finance research program.
1. An Inconvenient Void
Climate finance is defined by the United Nations Framework Convention on Climate Change (UNFCCC) to be “local, national, or transnational financing—drawn from public, private, and alternative sources of financing—that seeks to support mitigation and adaptation actions that will address climate change.” It is about investments that governments, corporations, and households have to undertake to transition the world’s economy to a low-carbon path, to reduce greenhouse gas concentrations levels, and to build resilience of countries to climate change. The European Commission estimates that energy and infrastructure investments, mainly from the private sector, would have to rise to 2.8% of European Union gross domestic product (GDP) from 2% today (or an additional |${\$}$|376 billion annually) to reduce EU net greenhouse gas emissions to zero by midcentury.1 Estimates for decarbonizing power generation in the United States are comparable. Absent mitigation and adaptation, a major scientific report issued by thirteen U.S. federal agencies in November 2018 predicted that the potential damage from the consequences of climate change would knock as much as 10% off the size of the U.S. economy by century’s end.2
These large estimates only coarsely encapsulate the significant risks of global warming for firm profits, capital markets, and household wealth. Many sectors, ranging from energy, food, and insurance to real estate, are directly impacted by risks generated by a potential price on carbon, adverse shocks to agricultural productivity, or exposures to rising sea levels, to name a few. Underlying these concerns are difficult questions regarding the distribution of damages from global warming, how society should price and mitigate risks from global emissions, and whether capital markets—to the extent that they can assess and price these exposures—can raise such large sums and potentially help households and institutions hedge climate change risks.
Answers to these questions in turn depend on expectations that agents in the economy hold. A case in point is that ongoing worries by some in the private sector about wavering commitments to the Paris Climate Agreement goals have prompted efforts to mobilize, such as the Climate Finance Leadership Initiative and the newly launched Principles for Responsible Banking.3 Such sustainable investing initiatives have the potential to influence the cost of capital for high carbon emissions companies even in the case of explicit carbon taxes. Raising the trillions necessary over the coming decades to address global warming will also no doubt rely on financial innovations.
Even though questions such as pricing and hedging of risks, the formation of expectations, and financial innovations are natural ones for financial economists to tackle, little research has been published to date in our top finance journals. The award of 2018’s Nobel Prize in Economics to William Nordhaus for his work on integrated assessment models for climate change going back to the mid-1970s (for example, Nordhaus 1977) reminds us of the missed research opportunity for financial economists to assess the risks associated with climate change as a global externality (Nordhaus 2019).
The current volume represents the effort of the Review to remedy this dearth of research on climate finance. It was a problem that the editorial team of the Review recognized back in 2016. To this end, the editors, with the support of the Society for Financial Studies, launched a competition in 2017 using a novel editorial protocol—a Registered Reports (RR) format—that drew 106 submissions from scholars around the world on the topic. This competition paralleled in structure another one focused on the similarly under-researched topic of fintech that was published in the Review in May 2019 (see Goldstein, Jiang, and Karolyi 2019).
The idea behind RRs, a peer-reviewed editorial protocol developed in the cognitive sciences by the journal Cortex, is simple. Authors submit for review a research plan that designs an experiment, outlines the data to be collected, and describes potential interpretations of what findings may come; expert reviewers judge the proposed plan on its merit and not on the basis of the findings. Further, editors offer in-principle acceptance of the submission before final results are known. While the primary goal of RRs is to eliminate disincentives to publish negative or non-results and to mitigate publication bias, the editors of the Review believed this would be the ideal editorial protocol for a topic as controversial as that of climate change and global warming.4 Not only would it allow for the truth about the potential economic consequences of climate change for financial markets to come to the fore, but it might provide the incentives needed to draw out hesitant scholars who might be inclined to take on new research on climate finance.
We, as the editors of this special volume, needed to secure additional support beyond that of the Society to make this competition work. Major financial support came from Norges Bank Investment Management for the preliminary project proposal workshop at Columbia University (November 2017) and for a conference co-hosted by Imperial College Business School in London (October 2018) at which the findings would be unveiled. We also received additional support from the Program for Economic Research at Columbia University, the Brevan Howard Centre at Imperial University, and two of the Prince of Wales’s charities, Accounting for Sustainability (A4S) and the University of Cambridge Institute for Sustainability Leadership (CISL).
The editorial team assembled a twenty-three-person scientific council of reviewers to help review the proposals among the first pass of 106 submissions and the finalists who were to be invited to the Columbia University workshop, at which a number of them served as discussants.5 We also drew on dozens of additional anonymous reviewers who participated in one or more of the three rounds of reviews that each of the ultimately nine successful proposals survived.
In the remainder of this editorial, we will outline how the research competition evolved and what we received, and then lay out the findings on climate finance that this special volume represents within what we view going forward as a broader climate finance research agenda.
2. Launching a Call for New Research on Climate Finance
Our call for proposals was launched on January 31, 2017. We purposefully allowed a short five-month window for proposals to come forward with a deadline of July 30, 2017, in order that the competitive process would feature bona-fide proposals true to the goals of the RR process.
In the call for proposals, we asked for research on a number of questions, including: (i) linking trends in global temperatures to firm and industry cash flows; (ii) modeling valuations of vulnerable sectors to a warming climate; (iii) agency, governance, and general incentive problems that might distort corporate climate risk management; (iv) the risks of stranded assets for energy- and carbon-intensive firms and industries; (v) the building of hedge portfolios of climate state variables; and (vi) understanding a firm’s climate risk exposures based on sparse corporate disclosures or environmental ratings by public/private agencies.
Our expectations about what might come forward were modest given that there were so few available working papers dealing with such questions. Remarkably, we received 106 proposals from 281 scholars affiliated with 183 different universities, government agencies, banks, and private firms from around the world. Many of those scholars are from outside North America. Figure 1 shows that only 46% (129) of the scholars on the proposal teams are domiciled in the United States and only 5% (14) are from Canada. Figure 2 demonstrates that it was younger scholars that revealed an appetite for climate finance research; 63% of the contributing scholars were either assistant professors (141) or Ph.D. students (23).
Composition of authors among RFS climate finance proposals submitted by geographic location
This figure reports the country of domicile of affiliated academic institution for the 409 authors among the 106 RFS climate finance proposals received by July 30, 2017, to the open call issued on January 31, 2017.
Composition of authors among RFS climate finance proposals by academic rank
This figure reports the rank of the 281 authors among the 106 RFS climate finance proposals received by July 30, 2017, to the open call issued on January 31, 2017.
Figure 3 shows that the largest number of proposals fell into what we called the category of “Carbon,” which focused on carbon trading, adaptation, and stranded assets. This was not unexpected, as climate economics as a line of inquiry had already delved into this area.6 The next largest category of submissions was under “Disclosure,” which examines mandated disclosures, the study of attitudes and actions of institutional investors and analysts; followed by “Investing,” which focuses on investing strategies, priced risk factors, and informational efficiency; “Uncertainty,” which examines modeling uncertainty, long-run risks, learning, beliefs, and ambiguity; and finally, “Weather,” which emphasized extreme weather risk.
Topic areas featured among the RFS climate finance Registered Reports proposals
This figure reports the topic areas among eight major topic areas among the 106 climate finance proposals received by July 30, 2017, to the open call issued on January 31, 2017.
3. Contributions to the Climate Finance Research Program
The final nine papers that make up this special issue on climate finance reflect the diversity of the topics addressed in the submissions. They ask questions and use tools that have been emphasized by financial economists and show how finance can contribute to the discussion on the impact of climate change. We frame these contributions along the lines of what we view as a reasonable climate finance research agenda going forward.
3.1 Uncertain social cost of carbon
There has been considerable work and controversy surrounding the choice of discount rates in the climate economics literature on the social cost of carbon. Gollier (2013) provides a useful review. Financial economics has emphasized the importance of the Arrow-Debreu insight that discounting of payoffs should be state-contingent. Barnett, Brock, and Hansen (2019) combine asset pricing methods and decision theory to estimate the social cost of carbon. They point out that this estimation must face both the uncertain impact of climate on human welfare and the uncertainty concerning models that describe the transmission mechanism of human activity to climate.
Barnett, Brock, and Hansen (2019) nest influential models in the literature, such as those of Nordhaus (1977) and Weitzman (2009). They show that the interaction of these two sources of uncertainty is multiplicative, such that the impact on the social cost of carbon is substantial when each component is important. They also show that the presence of ambiguity aversion and aversion to model misspecification can substantially increase the estimates of the social cost of carbon. Their methodology shows how one can effectively integrate simplified models developed by physical scientists with tractable models of the economic damage caused by climate change.
3.2 Hedging climate risks
While Barnett, Brock, and Hansen (2019) demonstrate how asset pricing approaches can inform even developed topics in academic research on climate change, Engle et al. (2019) show how traditional portfolio approaches can raise new topics such as how to hedge climate risks. They use another standard tool of asset pricing, namely that of mimicking portfolios, to build portfolios that are hedged against innovations in climate change news. They start by constructing a series of innovations on views on climate change using textual analysis of newspapers and then use the mimicking portfolio approach to build climate-change-news hedge portfolios. Engle et al. (2019) then show that the mimicking portfolios they construct can successfully hedge the innovations in climate change news using a number of out-of-sample performance tests. To the extent climate change news is a good proxy for underlying climate change risks, their mimicking portfolio approach can serve as a hedge against climate change risks.
This work harkens back to a large finance literature on economic tracking portfolios and macroeconomic variables such as GDP. An interesting avenue for future research would then focus on the extent to which temperature or other climate variables such as droughts can be economically tracked using the returns of stock portfolios.
3.3 Efficiency of capital markets and climate change
Given the macroeconomic impact of climate change, asset prices should be particularly sensitive to the exposure of their cash flows to climate risks. Murfin and Spiegel (2019) use a data set of recent residential real estate transactions matched with property level elevation and tidal data to ask whether house prices reflect differential sea level rise risk. In particular, they are able to separate the impact of sea level rise as distinct from the hedonic value of property elevation by using the pace of land subsidence and rebound as a source of variation in the expected pace of regional relative sea level rise. In contrast to the work of Bernstein, Gustafson, and Lewis (2019) or Baldauf, Garlappi, and Yannelis (2019), their findings indicate limited price effects, perhaps due to optimism about sea level rise or the possibilities of mitigation and bailouts.
Baldauf, Garlappi, and Yannelis (2019) use transactions data to measure the effect of flooding projections of individual homes and local measures of beliefs about climate change on house prices. They document that houses projected to be underwater in believer counties sell at a discount when compared with houses in denier counties, suggesting substantial difference-in-beliefs across locations. In contrast to Murfin and Spiegel (2019), Baldauf, Garlappi, and Yannelis (2019) emphasize the importance in beliefs about climate risk to how or if it is priced. Also, the National Oceanic and Atmospheric Administration (NOAA) data they use ignores land rebound and subsidence but accounts for local and regional tidal variability and variation in property risk due to protective land topography between a property and the nearest shoreline.
These two papers directly address an important and wide-ranging debate on the efficiency of capital markets in pricing risks associated with climate change. And whereas regulatory discussions on market efficiency have mostly focused on the “stranded asset issue” (or energy corporations’ exposures to potential carbon taxes), these papers point to more general vulnerabilities of other asset classes to climate change risks such as agricultural output from droughts (Hong, Li, and Xu 2019) or even aggregate stock market performance (Bansal, Kiku, and Ochoa 2016).
3.4 Beliefs and climate change risks
Beliefs play a crucial role in financing new technologies for climate mitigation and in determining prices of assets that are sensitive to climate change. Hence, characterizing the beliefs of investors and of key insiders of corporations such as CEOs is crucial to the efficient markets debate when it comes to pricing of climate change risks.
Three papers in this issue deal directly with the impact of beliefs. Choi, Gao, and Jiang (2019) seek to measure the impact of abnormally high local temperature on beliefs about climate change. They document that Google search volume for “global warming” in different cities around the world increases when the local temperature is abnormally high, indicating that attention to the topic increases at those times. In addition, by examining trading volume and returns in the stock markets of those cities during these events, retail, but not institutional, investors sell carbon-intensive stocks, and carbon-intensive firms underperform firms with low emissions.
Although institutional investors do not react to abnormal local temperature, Alok, Kumar, and Wermers (2019) document that professional money managers overreact to large climatic disasters that happen close to them, underweighting disaster-zone stocks to a much greater degree than distant mutual fund managers. They also document that this overreaction can be costly to fund investor performance.
Krueger, Sautner, and Starks (2019) survey global institutional investors on perceptions related to climate risk. They find that although institutional investors rank climate risk down the ranks relative to financial, legal, and operational risks, they still regard them to be important. The investors also believe these risks already affect firms they invest in. In addition, many investors report that they do take actions related to climate risks. Risk management and engagement are considered preferable to divestment. Krueger, Sautner, and Starks (2019) also found that these institutional investors believe that equity valuations in some sectors do not fully reflect climate risks.
3.5 Damage functions
A crucial input for analysis of climate change risks is the causal impact of higher temperatures on economic activity, what is called the distribution of damages. A large economics literature finds that years with abnormally higher temperatures (due to exogenous weather fluctuations) lead to lower economic activity in less developed countries. The literature argues that one can use these estimates to extrapolate the likely impact of 2|$^{o}$| Celsius increases on output holding fixed any adaptations (Dell, Jones, and Olken 2014; Schenkler and Roberts 2009). This analysis is subject to two caveats: (i) adaption in the long run should lessen the shock; (ii) climate scientists emphasize that short-term temperature variations are not a reliable gauge of long-run climate change, particularly if there are tipping points in damage functions.
Addoum, Ng, and Ortiz-Bobea (2019) extend this literature to account for the effects of temperature on establishment sales by building a detailed panel of temperature exposures for economic establishments across the United States to estimate how location-specific temporary temperature shocks affect establishment-level sales and productivity. They find that the population average effects on sales and productivity of these shocks are close to zero, indicating that establishments are able to accommodate these temporary shocks. This conclusion is subject to a caveat that long-run changes in temperature can and do lead to a rise in extreme weather risks. So extrapolating from short-term temperature changes is also potentially problematic for this reason. This study suggests that companies in developed countries are less likely to be affected by extreme temperature, at least on average.
3.6 Short-termism and corporate emissions
Given that corporations and insiders (CEOs) ultimately need to make investments to address climate change, two traditional corporate finance issues loom large: agency problems associated with corporate short-termism and financing constraints. Even absent the issues of externalities, agency and financial constraint consideration can result in a less than first-best level of investment to address climate change.
To this end, Shive and Forster (2019) use data on greenhouse gas emissions to show that independent private firms are less likely to pollute or incur Environmental Protection Agency (EPA) penalties than public firms. These results suggest that ownership structure, and hence agency and horizon considerations, may affect the climate change impact of firms. It would be interesting to further link emissions to real innovations as measured by patents geared toward climate change risks.
4. Where Does Climate Finance Research Go from Here?
The taxonomy that we have laid out above is not a bad place to start as far as advancing the climate finance agenda. However, there are several other areas not covered by our set of nine papers that we think researchers should also tackle.
We see an important open question about the modeling and sharing of extreme weather risks. Extreme weather risks, such as the impact of Hurricane Sandy in 2012 on New York City property prices or the impact of the 2018 California wildfires on the Pacific Gas & Electric bankruptcy, are a reminder that climate change risks need not be confined to long horizons. Scientists predict that climate change will lead to more frequent and ever more extreme weather risks. Remote sensing (primarily through satellite or drone imaging) and machine learning can potentially help companies and society manage these risks.
Financial economists can use these tools to characterize the loss distributions using insurance data for floods or fires. These distributions in turn can depend on locational decisions by households and firms, technology decisions (such as by means of fire suppression or building codes) in terms of mitigating the damage of disasters, and the underlying weather processes themselves. Modeling these interactions and how they contribute to tail risks would be valuable for managers and policy makers.
Beyond modeling these loss distributions, the insurance and mortgage industries play critical roles in facilitating risk-sharing and extending credit in the aftermath of extreme weather events. Recent work by Ouazad and Kahn (2019) shows that mortgages in areas adversely affected by hurricanes are more likely to be securitized. This evidence is suggestive of the important role played by the finance industry in helping households manage climate risks.
A second major research push should focus on divestment, stranded assets, and the consequences for financial stability. Energy companies have become the new “sin stocks” facing divestment campaigns and lawsuits from shareholders alleging misleading disclosures regarding the costs of climate change. These divestment and legal campaigns are similar to what tobacco companies faced a generation ago and have the potential to influence the cost of capital of these companies (see, among others, Heinkel, Kraus, and Zechner 2001; Hong and Kacperczyk 2009). Recent work by Bolton, and Kacperczyk (2019) documents that institutions might indeed already be screening out companies of high carbon exposure based on similar considerations.
Such a divestment scenario in conjunction with lawsuits and lobbying for potential regulation would lead to significant stranded asset risk. Given the importance of the energy sector, this could be just the kind of systemic or financial stability type of event raised by outgoing Bank of England governor Mark Carney (2015). Modeling this stranded asset risk requires integrating analyses of lobbying and regulation into otherwise standard asset pricing or corporate finance frameworks and would be extremely interesting.
A third research initiative is on the impact of climate change on municipal finance. Cities are increasingly affected by severe weather events. Even abnormal precipitation can cost millions to clean up and stretch already limited city budgets. Ratings agencies are considering incorporating climate change resilience measures into municipal bond ratings. How to measure resilience of municipalities and the impact of this resilience on municipal bond prices would be valuable. There is some preliminary evidence that municipal bonds have begun responding to some of these potential risks (Painter Forthcoming).
A fourth research agenda should focus on the impediments to corporate and financial innovation related to climate change. Despite numerous papers in climate economics, there is surprisingly little on corporate adaptation to climate change via innovations. The few notable exceptions include Miao and Popp (2014), who address how droughts lead to more patent activity geared toward drought-resistant crops. Given the rich literatures in corporate finance on the determinants of corporate innovation and patent activity, a focus on the subset of patents associated with adaptation to climate change and the determinants or impediments to such adaptations would be valuable. To fund these corporate innovations, there will no doubt also have to be financial innovations. Some of these innovations, such as green bonds, are gradually emerging (Flammer 2018; Baker, Bergstresser, Serafeim, and Wurgler 2018), and the nature and impact of such innovations will be worthy topics of future study.
5. One Final Remark
Even though we financial economists are late to the game, we hope that this climate finance issue illustrates that there are many important questions where financial economists are naturally suited given their toolkit and interests. We are confident that the engagement of the broader academic finance community on these issues will no doubt lead to valuable contributions to improving the usefulness of the finance field to help society address perhaps unprecedented risks from climate change in the upcoming years.
Acknowledgement
This editorial is written for a special issue of the Review of Financial Studies focused on climate finance. The authors served as the editors of the special issue of papers, which was curated using a Registered Reports editorial format. The papers were presented at a workshop event in November 2017 at Columbia University and at a conference hosted by Imperial College London in October 2018. The presentations by the authors and the comments from plenary discussions at the workshop and conference were valuable in shaping the views shared in this editorial. We thank Norges Bank Investment Management (NBIM) and the Norwegian Finance Initiative (NFI) for substantial financial support and the invaluable advice of Wilhelm Mohn and Carine Smith Ihenacho of NBIM without which the workshop and conference events could not have happened. We thank the Program in Economic Research at Columbia University, Stephanie Cohen, and Sophia Johnson for help with the workshop. We thank Franklin Allen, Jaswinder Gil, and the Imperial College Business School’s Brevan Howard Centre for Financial Analysis for help with the London conference. Comments on this editorial are gratefully acknowledged from Jawad Addoum, Shashwat Alok, Darwin Choi, Jessica Fries, Lorenzo Garlappi, Itay Goldstein, Matt Linn, Justin Murfin, Sophie Shive, Matt Spiegel, Alexis Wegerich, and Zacharias Sautner. We finally thank the members of the Scientific Review Committee who agreed to help with this initiative as well as Charlie Donovan, Jessica Fries, Hannah Brockfield, Andrew Voysey, Nina Seega, and Yazid Sharaiha. Editorial assistance was gratefully received from Managing Editor Jaclyn Einstein and Dawoon Kim. Of course, all errors in the editorial remain the responsibility of the authors.
Footnotes
1 See “EU’s 2050 Climate Plan Sees Benefits of Up to 2% of GDP,” Euractiv, November 28, 2018. See also the joint letter to Commissioner Miguel Arias Canete from ministers from ten EU countries charting a “credible and detailed path” to net-zero emissions by 2050.
2 See “U.S. Climate Report Warns of Damaged Environment and Shrinking Economy,” New York Times, November 23, 2018.
3 According to the International Energy Agency, spending on renewable power such as wind, solar and biomass projects slipped 1% in real terms to |${\$}$|304 billion in 2018, the lowest level since 2014 (“Falling Renewables Investment Stalls Paris Climate Goals,” Financial Times, May 14, 2019). Former mayor Michael Bloomberg, the UN Secretary-General’s Special Envoy for Climate Action, together with former SEC chairperson Mary Schapiro, announced the Climate Summit for the 74th UN General Assembly in September 2019. The UN Environment Program’s Finance Initiative launches the Principles for Responsible Banking at the same UN General Assembly.
4 The concept was outlined on May 3, 2013, in an editorial by Chambers and Della Sala (2013), entitled “Journal Cortex Launches Registered Reports.” Further details are in Chambers et al. (2014). Our editors are grateful to Chris Chambers for his advice early in planning in 2016, as well as helpful discussions with Brian Nosek of the Center for Open Science, which tracks all publications across disciplines using RR formats, and Rob Bloomfield and Christian Leuz of the Journal of Accounting Research, which published its own RR special volume in 2018.
5 We want to thank our committee including Ravi Bansal, Patrick Bolton, Francesca Cornelli, Magnus Dalhquist, Robert Engle, Xavier Gabaix, Stefano Giglio, Michael Goldtsein, Valentin Haddad, Lars Hansen, Leonid Kogan, Ralph Kojien, Per Krusell, Robert Litterman, Christopher Sims, David Sraer, Heather Tookes, Rossen Valkanov, Jessica Wachter, Jiangmin Xu, Jialin Yu, and Motohiro Yogo.
6 According to the Social Sciences Research Network (SSRN), there are 772 working papers posted (as of July 20, 2019) that fall under the topic area of “carbon trading” and another 45 under “stranded assets,” and the vast majority of those were posted before 2019.
