Facilitating Climate-Smart Investments

Journal of Economic Surveys

The financial risks and potential systemic impacts induced by climate change and the transition to a low‐carbon economy have become a central issue for both financial investors and their regulators. In this article, we develop a critical review of the empirical and theoretical literature concerning the impact of climate‐related risks on the price of financial assets. We first present the theoretical links between asset pricing and climate‐related risks and develop a theory of how climate risk drivers transmit costs to firms and lead to asset price changes. We then discuss studies looking at past climate‐related events, which show that both climate physical impacts and transition dynamics can trigger a revaluation of financial assets through multiple direct and indirect channels. Finally, we review the emerging literature that uses forward‐looking methodologies to estimate future climate‐related asset price changes, which suggests that climate financial risks can indeed have signific...

CASCADES paper, 2022

Is climate change a financial risk that financial institutions need to worry about? Despite the rapid increase in climate financing and the rise of the dominant discourse on the importance of climate change and environmental, social and corporate governance (ESG) criteria, financial markets do not seem to show much sensitivity to the increasing climate risks. The problem arguably lies in the fact that the markets seem to have difficulties estimating the specific costs of climate change, which, although potentially high, often remain long-term and uncertain. The benefits of adjusting to climate risks also seem harder to quantify for shorter-term investments. Most international actors that provide development finance seem to have difficulty estimating the specific costs of climate change risks. Climate risks can be low or high, short-term or long-term, and more or less uncertain. Yet, understanding the particular nature of climate risks clearly could help in pricing climate-risk finance and the proper allocation of funding for climate action. In particular, investments in climate adaptation, which are perceived by many financial actors as a costly endeavour, could become financially more attractive if the corresponding reduction in climate risk exposure were not only qualitatively considered, by explicitly priced. This would have serious implications for development finance institutions and their incentive to invest in climate adaptation operations in developing countries most affected by climate change, with a high socio-development impact. This paper considers why effective climate risk assessment should matter for financial institutions. We present different approaches to measuring climate risk used by some European financial institutions with a public mandate, including a multilateral development bank (MDB) - the European Investment Bank (EIB), development financial institutions (DFIs) - the British International Investment (BII) and the Dutch entrepreneur development bank (FMO), national promotional and development banks - the German Kreditanstalt für Wiederaufbau (KfW) and Italian Cassa Depositi e Prestiti (CDP); and export credit agencies - the Atradius Dutch State Business (Atradius DSB), and French Bpifrance. These institutions have adopted climate, and often explicit ESG, approaches and climate risk assessments. Increasing efforts are also dedicated to further improving their approaches. Yet, they encounter several difficulties and limitations in their attempt to assess climate risks. Limitations encountered in climate risk assessment that could lead to mispricing include: 1. Underestimation or overestimation of the climate risks 2. Lack of proper methodologies to measure climate risks 3. Assessments are generally done at the macro-level 4. Data on climate risk variables is usually missing 5. Lack of a central database providing data on all climate risk indicators 6. No harmonised industrial standards and a proper regulatory framework It is essential to overcome the challenge of climate change mispricing (over- and under-estimation) of the risks to ensure that physical and transition risks are precisely predicted. This necessitates that financiers and investors, in general, alter their strategies, incentives and approaches, including by exploiting the opportunities provided by climate risk assessment models and strategies. Development financiers can play a pioneering role in that respect. MDBs like the EIB and DFIs like BII and FMO should not only continue their respective current endeavours to further enhance their overall climate/ESG, and climate-risk assessment approaches. They should also coordinate their efforts to lead the (European) development finance community in better addressing climate change, improve risk assessment approaches and try to explicit price climate risks. By doing so, they can also leverage private finance actors and have a catalytic demonstration effect on how to better climate risks. While climate finance has significantly increased for mitigation, it is seriously lagging for adaptation. In particular, in Europe, financial institutions for development have generally failed to invest at scale in climate adaptation, often arguing that they are not enough bankable projects. Improving climate risk approaches, explicitly pricing climate risks, can play a significant role in boosting private and public finance to tackle climate change, including for adaptation. In terms of physical climate risk, there is a need to adopt proper methodologies to assess the risk from chronic and acute shocks on a highly granular level and connect asset-level physical risks to firms’ and investors’ financial risks. Such enhanced approaches could usefully draw on Bressan et al. (2022). They developed the first comprehensive methodology that logically connects asset-level physical risks to financial risks for firms and financial actors and, more broadly, to systemic risk for the financial system. It does so by translating economic losses on physical assets and sectors from chronic and acute climate physical risks into financial losses and shocks on prices in the market. It allows for a dynamic, asset-level assessment of physical climate risk, considering the cascading losses through the ownership chains of firms and investors. Key policy recommendations for financial institutions that could lead to better assessment and improved climate risk pricing include: 1. Develop a reliable database to provide information on climate-related risks 2. Improve the transparency of the risk assessment methodologies 3. Develop harmonised climate risk assessment methodologies 4. Support the establishment of project-level climate risk assessment 5. Exploit the potential of insurance companies 6. Address the information asymmetry and knowledge gaps 7. Enforce climate-related regulation at all levels 8. Embody climate risk assessment in overall sustainable investment strategy and use concessional financing to cover high climate risks 9. Explicitly price climate risks and net returns from climate adaptation. This work was conducted in the European Commission H2020-funded CASCADES (CAScading Climate risks: towards ADaptive and resilient European Societies) project, Grant agreement number 821010. https://www.cascades.eu/publication/climate-risk-mispricing-why-better-assessments-matter-in-financing-for-development/

2019

The financial sector must prepare for a higher risk level associated with climate change impacts affecting real estate and infrastructure, as well as climate policies that will impact risk and returns from investments in various sectors. Representatives from twenty financial institutions in Norway and Sweden have been interviewed on perceptions and management of climate change risks. The purpose was to map knowledge and perceptions, examine current management of climate-related risks and explore how risk management can be improved within these institutions. Frequently only qualitative assessments of climate risk are made in the financial sector, because data are missing, or there is high uncertainty attached to the figures. Carbon footprint and energy use or intensity are the most common climate risk indicators, but these are insufficient measures to fully assess climate risk. Few institutions have made substantial changes in the organization of their business. Climate risk is often...

British Actuarial Journal, 2022

This paper illustrates the potential impacts of climate change on financial markets, focusing on their long-term significance. It uses a top-down modelling tool developed by Ortec Finance in partnership with Cambridge Econometrics that combines climate science with macro-economic and financial effects to examine the possible impacts of three plausible (not extreme) climate pathways. The paper first considers the impact on gross domestic product (GDP), finding that GDP is lower in all three pathways, with the most severe reduction in the Failed Transition Pathway where the Paris Agreement climate targets are not met. The model then translates these GDP impacts into financial market effects. In the Failed Transition Pathway, cumulative global equity returns are approximately 50% lower over the period 2020–2060 than in the climate-uninformed base case. For the other two pathways where the Paris Agreement targets are met, the corresponding figures are 15% and 25% lower returns than in t...

Climate Change and Law Collection

• Today, the financial sector is exposed to the physical risks associated with climate change and the impact of climate policies. Securing global financial and economic stability and scaling up low-carbon, climate-resilient investments are not conflicting, but rather mutually reinforcing, objectives. • Although crucial, classic climate policies-such as carbon pricing, emission standards and technology objectives-do not appear sufficient to address the challenges from climate change that the financial sector is facing. Policies affecting the demand side and supply side of finance, as well as instruments matching supply and demand, need to be aligned with climate objectives to efficiently shift investments toward a low-carbon, climate-resilient economy. • The financial sector and its governance bodies have an interest in integrating climate change issues into their risk and stability assessment frameworks, but seemingly differing mandates and the lack of institutional and intellectual links are hindering a timely and well-informed discussion. • Once the link between climate change and the mandates of international financial sector governance and regulatory institutions is understood, the existing tool kits and processes of these institutions-common standards, principles and guidelines with various levels of legal force, country surveillance and technical assistance-present entry points to mainstream climate-related risks and opportunities into their core operations. 1 This brief is based on two longer working papers published by the authors (see Morel et al. 2015).

2012

NATURE CLIMATE CHANGE | VOL 5 | MAY 2013 | www.nature.com/natureclimatechange 1 T he scientific understanding of climate change and its impacts has increased dramatically in recent years, but several interacting sources of uncertainty mean that future climate change and its impacts will not be known with precision for the foreseeable future. Some uncertainties involve the path of global socioeconomic development, the way it affects the commitment by countries to use energy-efficient technologies and how greenhouse-gas emissions might respond to specific climaterelated policies. Other uncertainties involve internal variability and incomplete understanding of the climate system and broader Earth-system feedbacks. Still other uncertainties involve the way that changes in climate translate to impacts such as changes in water availability, agricultural production, sea-level rise or heat waves in different parts of the world. A final set involves the evolution of assets at risk (exposure) both in physical and in monetary terms and the level of protection that can be undertaken to reduce their vulnerability to potential losses (that is, adaptation measures). The implication of these interacting sources of uncertainty is that choosing among climate policies is intrinsically an exercise in risk management.

SSRN Electronic Journal, 2011

Nature Climate Change, 2016

Investors and financial regulators are increasingly aware of climate-change risks. So far, most of the attention has fallen on whether controls on carbon emissions will strand the assets of fossilfuel companies. 1,2 However, it is no less important to ask, what might be the impact of climate change itself on asset values? Here we show how a leading Integrated Assessment Model can be used to estimate the impact of 21 st century climate change on the present market value of global financial assets. We find that the expected 'climate value at risk' (climate VaR) of global financial assets today is 1.8% along a business-as-usual emissions path. Taking a representative estimate of global financial assets, this amounts to $2.5 trillion. However, much of the risk is in the tail. For example, the 99 th percentile climate VaR is 16.9%, or $24.2 trillion. These estimates would constitute a substantial write-down in the fundamental value of financial assets. Cutting emissions to limit warming to no more than 2°C reduces the climate VaR by an expected 0.6 percentage points, and the 99 th percentile reduction is 7.7 percentage points. Including mitigation costs, the present value of global financial assets is an expected 0.2% higher when warming is limited to no more than 2°C, compared with business as usual. The 99 th percentile is 9.1% higher. Limiting warming to no more than 2°C makes financial sense to risk-neutral investors-and even more so to the risk averse.

Journal of Technology Management for Growing Economies

In light of the observed changes in climate patterns, this paper reviews the evidence forwarded under climate science research for analysing the climate related stresses on assets across different sectors. The review provides insights on the need for a shift in investment decisions and portfolio management activities. The paper follows an exploratory research method to focus on key climate science research themes. Thereby, the paper synthesizes the existing scientific information to identify those opportunities in climate change that require climate investments. Additionally, the research also discusses the points of uncertainty for climate investment that arise due the limitations of existing climate science related information and methods. The synthesis of climate science information in the paper will provide a foothold to the interdisciplinary research community in the area of sustainable investments for identification of investable climate assets and insights on the factors of c...

2018

Nature Climate Change, 2018

The academic and policy debate regarding the role of central banks and financial regulators in addressing climate-related financial risks has rapidly expanded in recent years. This Perspective presents the key controversies and discusses potential research and policy avenues for the future. Developing a comprehensive analytical framework to assess the potential impact of climate change and the low-carbon transition on financial stability appears to be the first crucial challenge. These enhanced risk measures could then be incorporated in setting financial regulations and implementing central banks' policies. [Main text] Achieving the objectives of the Paris Agreement will require a large-scale shift towards low-carbon technologies. However, socio-technological transitions often involve disruptive adjustments, even when they are ultimately beneficial to human welfare. 1,2 This process of 'creative destruction' is likely to take place also during the low-carbon transition, with potentially significant repercussions on economic dynamics and financial stability. 3,4 Societies thus face the challenging task of achieving a rapid structural shift to a low-carbon economy, while concurrently avoiding excessive economic losses and safeguarding the stability of the financial system (see Table 1).

Risk Governance and Control: Financial Markets and Institutions

This study focuses on climate-related financial risks as a governance issue, which drives our attention to the quality of stakeholders’ interactions. The theoretical approach is undertaken through the institutional literature lens, along with the works of Rawls (1971, 2001) and Sen (1992, 2000, 2009), and contributions from the conceptions of co-creation and inclusive development. The applied analysis is carried out by connecting climate change to financial risks under a scenario of uncertainty (Bolton, Despres, Pereira da Silva, Samama, & Svartzman, 2020; TCFD, 2017; Daniel, Litterman, & Wagner, 2019; Carney, 2016; Maier et al., 2016; NGFS, 2018, 2019). The core objective of this study is to present a public policy proposal that aims to support effective international climate-related agreements, from a procedural perspective. To this end, we start by presenting an institution, which is broken down into three propositions. This process enables us to undertake a critical analysis fro...

2020

This paper is directed to the financial community and focuses on the financial risks associated with climate change. It, specifically, addresses the estimate of climate risk embedded within a bank loan portfolio. During the 21st century, man-made carbon dioxide emissions in the atmosphere will raise global temperatures, resulting in severe and unpredictable physical damage across the globe. Another uncertainty associated with climate, known as the energy transition risk, comes from the unpredictable pace of political and legal actions to limit its impact. The Climate Extended Risk Model (CERM) adapts well known credit risk models. It proposes a method to calculate incremental credit losses on a loan portfolio that are rooted into physical and transition risks. The document provides detailed description of the model hypothesis and steps. This work was initiated by the association Green RWA (Risk Weighted Assets). It was written in collaboration with Jean-Baptiste Gaudemet, Anne Gruz,...

Environmental Science & Technology, 2009

Climate change mitigation requires a rapid decrease of global emissions of greenhouse gases (GHGs) from their present value of 8.4 GtC/year to, as of current knowledge, approximately 1 GtC/year by the end of the century. The necessary decrease of GHG emissions will have large impacts on existing and new investments with long lifetimes, such as coalfired power plants or buildings. Strategic decision making for major investments can be facilitated by indicators that express the likelihood of costly retrofitting or shut-down of carbon intensive equipment over time. We provide a set of simple indicators that support assessment and decision making in this field. Given a certain emissions target, carbon allowance prices in a cap-and-trade plan will depend on the development of the global economy and the degree to which the target is approached on the global and national levels. The indicators measure the degree to which a given emissions target is approached nationally and assess risks for long-lived investments subject to a range of emissions targets. A comparative case study on existing coal-fired power plants with planned plants and utility-scale photovoltaic power-plants confirms that high risk for coal-fired power plants is emerging. New legislation further confirms this result.

How significant are the impacts of man-made climate change today? The summer 2003 European heat wave had disastrous consequences: water shortages shut down 14 nuclear plants at electricity producer EDF, causing electricity price spikes of 1,300 percent, which, because they could not be passed on to customers, resulted in a $300 million loss; European agriculture lost an estimated $15 billion; and more than 35,000 people died. The ripple effects dramatically affected upstream and downstream sectors of various regions. France, the largest energy exporter in Europe, cut its energy exports by more than 50 percent. Output of animal fodder fell by up to 60 percent, and despite imports from countries not affected by the heat wave, such as Ukraine, livestock producers were affected by shortages and price hikes. Without man-made climate change, a summer as hot as 2003 would have been an exceptional "1-in-1,000-year" event. Due to man's influence on the climate, by 2003 the risk of such an event had already more than doubled to 1 in 500 years. By 2040 summers as hot as 2003 will be "normal," 1-in-2-year events, and by 2060 they will be cooler than the average (COPA/COGECA 2004; Stott et al. 2004; UNEP 2004).