Lecture 2: Climate Finance and Capital Structure

Lecture 2: Climate Finance: Some Financial Implications

• The lecture covered the financial implications of climate finance.
• The agenda included capital structure, cost of capital, climate risk, penalties vs. costs of change, externalities and regulation, types of market-oriented tools, costs and benefits of environmental laws, and the trade-off between economic output and environmental protection.

Capital Structure

• A project can be financed by equity or debt.
• Project value (V) is the sum of shareholder value (S) and debtholder value (B): V = S + B.
• Capital structure is characterized by the ratio B/S.
• Different corporations have different capital structures.
• Key questions include: Is there an optimal capital structure? Does capital structure maximize value (V)? What is the impact of more or less debt on value? What are the capital structure determinants per industry? How do these determinants depend on market timing?

Capital Structure: M&M Results

• Assumes homogeneous expectations, homogeneous risk class, perpetual cash flows, perfect capital markets (perfect competition, equal borrowing/lending rate, equal access to information, no transaction costs, no taxes).
• In a world of perfect markets without taxes, the value of a firm is not affected by its capital structure (Proposition M&M I).
• In the absence of arbitrage opportunities, capital structure cannot create value (Proposition M&M I).
• The presence of debt increases shareholder risk and expected payoff as a linear function of the debt-equity ratio (Proposition M&M II).

Capital Structure: Summary (No Taxes)

• In a world of perfect markets without taxes, the value of a firm is not affected by capital structure.
• Shareholders can achieve desired returns through homemade leverage (Proposition M&M I).
• Debt increases shareholder risk and expected payoff as a linear function of the debt-equity ratio (Proposition M&M II).

Capital Structure: Summary (With Taxes)

• In a world of perfect markets with taxes, firm value increases with debt (VL = VU + TcB).
• Tax advantages of debt allow shareholders to achieve desired returns through homemade leverage.
• Debt's presence decreases the rate at which the expected return increases as a function of the debt-equity ratio.

Cost of Capital

• The goal is to relate the cost of capital to project risk.
• Shareholders' risk is the risk of firm shares.
• No debt: Ro = Rf + Bo[Em - Rf].
• With debt: Rs = Rf + ẞs[Em - Rf] (assuming debt is riskless: βb = 0 ⇒ Rb = Rf).
• From security market line (CAPM): Rs = Rf + ẞs[Em - Rf]; Ro = Rf + Bo[Em - Rf] (where Em is market risk premium).

Climate Risk and Cost of Capital

• Climate risk significantly impacts firm costs of capital in several ways:

1. Increased risk perception: climate-related risks (e.g., extreme weather, regulatory, reputational) can increase investor perception of overall risk, leading to higher expected returns for compensation.
2. Valuation impact: climate-related risks affect asset valuations and future cash flows. For instance, fossil fuel industries may face devaluation due to concerns about stranded assets or regulations.
3. Regulatory and policy changes: climate-related regulations (e.g., carbon pricing, emissions reduction) can directly impact firm costs (compliance, taxation, penalties).
4. Physical risk and business disruptions: physical risks (extreme weather, sea-level rise, supply chain disruptions) can disrupt operations, damage property, and increase insurance costs.
5. Reputational risks and stakeholder perception: negative public perception (protests, boycotts) related to climate practices can harm a company's brand image and affect market value.
6. Transition risks: transition to a low-carbon economy creates risks and uncertainties (changes in market preferences, technologies, regulations).

Penalty vs. Costs of Change

• Regulations imposing procedures or penalties (c or t in perpetuity) decrease shareholder but not debtholder cash flows.
• The penalty's effective size depends on the cost of implementation and should be proportionate to the harm caused by non-compliance and potential benefits lost.
• Deterrence and enforcement, cost-benefit analysis, and proportional and graduated approaches are key considerations.

Externalities and Market Failure

• Private markets don't consider all social costs.
• Pollution is a negative externality: costs produced by a firm affecting parties not involved in the transaction (e.g., impacts on public health, property values, etc.).
• Governments can influence firms' decisions by imposing costs related to externalities, shifting the private supply curve to reflect social cost.
• Market failure occurs when private costs of production do not equal social costs.

Market-Oriented Environmental Tools

• Market-oriented policies create incentives for flexible pollution reduction. Key methods include pollution charges (taxes imposed on the quantity of pollution), marketable permits (allowing a specified quantity and sale of permits between firms), and clarified property rights (establishing clear ownership to help incentivize environmentally friendly land management).

Benefits and Costs of Environmental Laws

• Benefits of environmental protection can include healthier populations and reduced healthcare costs from clean air. The benefits accrue to industry (farming, fishing, tourism.) and often include unmonetarily valued benefits.
• Costs of environmental protection can be high and can vary based on the contaminant and the specific regulation.

International Environmental Issues

• Environmental problems like global warming and biodiversity are international externalities that transcend national borders.
• Finding solutions requires international cooperation, negotiations, and possibly shared costs between high-income and low-income countries.

The Trade-Off between Economic Output and Environmental Protection

• There is a trade-off between economic output and environmental protection, representing differing social preferences across countries with respect to that balance.
• Using a Production Possibility Frontier (PPF) graph helps model this trade-off to understand the opportunity cost of choosing one over the other.