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Climate and Finance:
Open Questions and Avenues for Future Research
Patrick Bolton
Columbia University
Assessing and Managing Climate-Related Financial Risks -- Paris December 16, 2016
Outline
1. The costs and benefits of abatement, the optimal
carbon tax and the vexing question of the
appropriate social discount rate
2. Investment in renewables and green bonds
3. Financial Innovation in secondary markets and
portfolio decarbonization
4. Corporate Governance & Engagement
I] Abatement and the social discount rate
How much should society be ready to pay today to
eliminate a sure loss of 1 million dollars in 200
years?
Present value
$ 1 000 000.00
$
100 000.00
$
10 000.00
$
1 000.00
$
100.00
$
10.00
$
1.00
$
0.10
$
0.01
Discount rate
0.00%
1.16%
2.33%
3.51%
4.71%
5.93%
7.15%
8.39%
9.65%
Stern uses 1.4%
Nordhaus uses 5%
March 30, 2016 Ireland issued a “century bond” with a yield of 2.35%
The Price of Climate Risk
 The question asked by Stern and Nordhaus is the
wrong question
 Contribution of Finance  Losses are uncertain
and finance is good at pricing risk
 Equity market risk premium
 The discount rate for green investments should be
equal to the return of a traded asset with the same
risk profile
 Two questions:
1. What is the market price of climate risk?
2. Does the market correctly measure climate risk?
Market Informational Efficiency and
Climate Risk
Hong, Li, Xu (2016):
 Corporations’ vulnerability to natural disasters
amplified by climate change
 Do financial markets under-weight such risks?
 How do markets respond to information about
drought risk?
 Lesk, Rowhani, and Ramankutty (2016): droughts
 average crop yield drop of 10%
Hong, Li, Xu (2016)
 Sample of 30 countries with large agriculture
sectors
 Increasing frequency of droughts in these countries
 How is profitability of food industry affected by
droughts?
 Palmer Drought Severity Index (PDSI) is a good
predictor of food industry profitability
 What about the relationship of PDSI and expected
returns?
 Efficient markets  effect of PDSI should be zero
or negative
Hong, Li, Xu -- 2
 Key Finding: A one-year position long in food
industry stocks of countries with high PDSI and
short in countries with low PDSI has an excess
return of 0.77% per month (Sharpe ratio = 0.5)
 Markets are unfamiliar with climate change risks
 Countries with high past PDSI under-weight
drought risk by more than twice the other countries
Finance and Climate Change
 Besides helping with valuation of future
benefits and costs, finance plays three
other important roles
1. Guiding capital allocation and financing the
transition to renewable energy
2. Hedging and climate risk allocation
3. Bring forward in time future carbon pricing
II] Guiding Capital Allocation
 Financing renewable energy investments
and research in energy efficiency
 Cannot do without major public subsidies
or some form of regulation/taxation of
GHG emissions
 Socially responsible investors increasingly
play a role by investing in green bonds
 Major Chinese initiative on green bonds
unveiled at the G-20 meetings in Hangzhou
Guiding Capital Allocation
Increase in Renewable investments
Guiding Capital Allocation
Falling cost of renewables is disrupting energy markets
Guiding Capital Allocation
Green bond issuance
Guiding Capital Allocation
Green bond issuance breakdown by country
Research questions relating to this
global energy transition
1. How fast and how far will renewable energy
costs fall?
2. How does the implementation of NDCs affect
the expected decline in renewable (and other
non-fossil) energy costs?
3. Is the market under-reacting to this energy
transition?
4. Is the “green paradox” already a reality and if
so what are the consequences?
IV] Financial Innovation to Hedge Climate Risk
 What should investors do if they want to
reduce their exposure to climate risk and
carbon pricing risk?
 Divest? But how should they divest while
limiting the financial consequences for their
investment returns?
 Sophisticated strategies for professionals
 Simple strategies for retail investors and
savers
Climate and Carbon Risk
• From an investor’s perspective => risk with
respect to both climate change and climate
change mitigation policies.
• Growing awareness among investors about
this risk factor.
• Still too few investors are aware of the carbon
footprint of the companies in their portfolios
and their stranded assets.
Limits of Divestment
• It is a ‘bet’ on renewable energy
• Exposes investors to substantial timing risk
• Harvard Endowment declined: the endowment is
“a resource, not an instrument to impel social or political
change”
• Fund Managers say that divestment may go against
their fiduciary duties:
“the duty of loyalty, likely preclude[s] a fiduciary from
eliminating the entire fossil fuel industry from its portfolio without
looking at each investment that would be effected on a case-by-case
basis.” Covington & Burling LLP for PBUCC
A Simple Strategy for fund managers:
Decarbonized Market Indices
• A Compromise: Reduce exposure to carbon risk
without changing other risk exposures
• Maximize carbon footprint reduction subject to
maintaining a minimum tracking error (TE) with
respect to a benchmark index.
A Low Carbon and Low TE Portfolio
• Basic logic: reduce exposure to the unpriced
carbon risk while otherwise maintaining exposures
to priced risk factors
• As long as carbon risk remains unpriced, the
decarbonized index will produce the same returns
as the benchmark index
• Once carbon risk is priced it will outperform
A Low Carbon and Low TE Portfolio 2
• Underlying premise:
• Financial markets currently underprice carbon risk.
• Eventually, if not in the near future, financial
markets will begin to price carbon risk.
=>
• A low-TE decarbonized index can provide
superior financial returns to the benchmark index
(see Andersson, Bolton and Samama, 2016 FAJ for
details)
A Free Option on Carbon
• Basic Concept:
• The decarbonized portfolio replicates market
returns…
• …until GHG emissions start being priced.
• At that point the decarbonized portfolio starts
beating the index.
A Low Carbon and Low TE Portfolio 3
• Choice of references:
• Index Providers (MSCI, FTSE, etc.)
• Carbon Data Providers (Trucost, CDP, etc.)
• Exclusion of high carbon stocks or an overall underweighting of high carbon stocks
• There are multiple possible approaches
• Still further research and experimentation with how
best to hedge climate change risk
MSCI Europe Low Carbon Leaders
MSCI
MSCI Europe
Low Carbon
Leaders
Total Return* (%)
12.7
13.1
Total Risk* (%)
13.2
13.3
Sharpe Ratio
0.95
0.99
Active Return* (%)
0
0.4
Tracking Error* (%)
0
0.6
Information Ratio
NA
0.72
Turnover** (%)
1.7
6.9
Securities excluded
NA
328
Market cap excluded (%)
NA
17.4
Carbon Emission intensity
reduction (tCO2/mm USD)
(%)
NA
50
Carbon Reserves intensity
reduction (tCO2/mm USD)
(%)
NA
68
Key Metrics
 Excludes:
– Largest 20% emitters with
a maximum 30% by weigh
form any sector
– Largest owners’ reserves
up to 50%
 Major reduction of:
– Carbon Emissions Intensity
(-50%)
– Carbon Reserves
(-68%)
 Low tracking error: 0.6 %
MSCI Europe Low Carbon Leaders
In bps
250
200
150
100
50
0
Nov 2014
May 2015
Nov 2015
Excess Return: MSCI Europe Low Carbon Leaders vs MSCI Europe
May 2016
MSCI Europe Low Carbon Leaders 2
• What are the tradeoffs?
MSCI Europe Low Carbon Leaders 3
• What are the tradeoffs?
• Sector composition of the benchmark index (more
than 90% of the world GHG’s emissions are
attributable to other sectors than Oil & Gas
(ClimateCounts, 2013))
• Size of companies in the benchmark index  divide
each company’s carbon footprint by sales, tons of
output, sales*kilometer distance, or total GWh
electricity production, etc.
• Rate of change of company’s carbon footprint 
take account of investments in emission reductions
Decarbonization Opportunities and Challenges
•
•
•
•
Global 500: 28% of world GDP = GDP of US + Japan
GHG emissions increased by 3.1% from 2010 to 2013
GHG emission estimates: voluntary reporting by 350
Emissions measured: Scope 1 (emissions from
operations) + Scope 2 (emissions from energy
consumed by operations), but not Scope 3
(emissions from value or supply chain)!
• Examples of change: 1) Total -11.8%; 2) Arcelor
Mittal +12%; 3) GDF Suez +42.4%; 4) Lafarge and
Holcim merger  5th largest emitter in the world
V] Corporate Governance & Engagement
• CALPERS & CALSTRS:
“We firmly believe that engagement is the first
call of action, and results show that it is the
most effective form of communicating concerns
with the companies we own”
• Prodding companies to reduce their GHG
emissions  APG: “On a regular basis we screen
our equity and bond portfolio and start engaging
with companies who we think are in breach of the
UN Global Compact Principles. Where
engagement does not lead to the desired change
we can decide to divest. ”
Engagement
• Number of shareholder resolutions relating to GHG
V] Corporate Governance & Engagement
• Two Problems:
1. How do we know whether engagement works at
all? And which engagement policies are most
effective?
2. How to coordinate investor engagement?
Could better reporting of ESG policies help?
• Research Questions:
• How should corporate governance account for
socially responsible investment?
• Have proxy advisors had any impact on ESG
factors?
Conclusion
• Major societal conflicts –the debate over climate
change—are reflected in financial markets
• They give rise to political uncertainty
• Ideological differences in societal conflicts are
reproduced in financial markets as differences of
opinion
• Scheinkman and Xiong (2003)  differences
of opinion + short-sales constraints =>
stock price = fundamental value +
speculative option value
Conclusion 2
• Hong, Li, Xu (2016)  limited attention =>
under-reaction to climate risk
• Both theories imply that climate risk exposure
should be carefully assessed and that portfolios that
underweight climate risk exposure will generate
higher returns….in the long run
Conclusion 3
• Socially responsible investing requires
coordination among institutional investors
• Need better and more standardized reporting on
ESG factors
• New entry & innovation in the proxy advisory
market with a dedicated sustainable investing
proxy advisory firm (CDP?)
• We need a parallel corporate convention on
climate change with an annual corporate COP
• Convener could be the WEF
• Corporations like Nations could make their own
IDCs….