Lecture 1 Climate Finance Framing the problem PDF

Lecture 1 Climate Finance Framing the problem Climate Finance Prof João Amaro de Matos Venice, Ca’ Foscari April 8th, 2024 Climate Finance: Framing the Problem Agenda Evidence Why does it matter for finance Types of financial risks associated to climate cha...

Lecture 1 Climate Finance Framing the problem Climate Finance Prof João Amaro de Matos Venice, Ca’ Foscari April 8th, 2024 Climate Finance: Framing the Problem Agenda Evidence Why does it matter for finance Types of financial risks associated to climate change Physical risk Transition risk Implications for financial sector and the public Cost of capital Systemic risk and stability of the financial system Burden on the public Ways to assess and manage climate financial risk Disclosure Risk Management Climate Stress Testing Climate Finance | João Amaro de Matos 2 Some Evidence Climate Finance | João Amaro de Matos 3 https://cpb-eu-w2.wpmucdn.com/blogs.reading.ac.uk/dist/3/187/files/2021/01/spiral_2020_large.gif Climate Finance | João Amaro de Matos 4 Economic growth, innovation and welfare… Hours of work required to produce 1,000 lumen-hours https://www.core-econ.org/project/core-espp/ Climate Finance | João Amaro de Matos 5 Economic growth and welfare… Climate Finance | João Amaro de Matos 6 …has happened in a period of stable climate James Watt invents the By RCraig09 - Own work, CC BY-SA 4.0, modern steam engine https://commons.wikimedia.org/w/index.php?curid=87832845 Climate Finance | João Amaro de Matos 7 Anthropogenic GHG emissions and CC Climate Finance | João Amaro de Matos 8 Why does it matter for finance? Climate Finance | João Amaro de Matos 9 Why does it matter for finance When an investor funds a venture, they do so with the hopes of earning more than they invested. However, investors risk financial loss if the venture underperforms or fails. This trade-off between risk and return is a fundamental consideration in any investment and leads investors to demand higher possible rewards for higher-risk investments. The presence and management of financial risk is ubiquitous across all sectors of the economy, although what that risk looks like differs by sector and by individual investment. Climate Finance | João Amaro de Matos 10 Why does it matter for finance The risk-return trade-off is an empirically well-established relationship implying that financial expected return increases with risk. Climate change will affect both the risk profile of a firm, and Its expected profitability (returns) In a simplified perspective, this happens through changes in firms’ operational environments and how these changes percolate through to the financial sector It is useful to think in terms of climate-related financial risks (and opportunities) Climate Finance | João Amaro de Matos 11 Why does it matter for finance As climate change warms the planet and actions are taken to reduce emissions, financial institutions must reckon with new and changing risks to assets and the broader financial system. This class will discuss the risks that climate change poses to financial systems and stakeholders. We shall as well discuss the actions taken to accurately account for these risks. Climate Finance | João Amaro de Matos 12 Types of Risk Climate Finance | João Amaro de Matos 13 Types of risks associated to climate change Physical Risks This is the risk associated to events that damage assets and infrastructure. Transition Risks This is the risk associated to the uncertain paths to a decarbonized economy. Climate Finance | João Amaro de Matos 14 Physical Risks Climate change is linked to rising temperatures and sea levels; changing precipitation; volatile weather; and an increase in the size and intensity of natural disasters like wildfires, hurricanes, and heatwaves. These events have and will continue to damage assets and infrastructure, displace communities, and disrupt supply chains and business operations. The risk carried by these changes is called physical risk. Climate Finance | João Amaro de Matos 15 Physical Risks A substantial amount of persistent, climate-related physical change is already “baked in” to geophysical systems: carbon dioxide, the main driver of climate change, remains in the atmosphere for hundreds of years after it is emitted and drives changes in physical risk for several decades. Therefore, for many institutions, the question is not only how to stop the physical changes from happening, but also how to account for and limit exposure to them. Climate Finance | João Amaro de Matos 16 Physical Risks: Impacts Businesses face substantial physical risks from climate change. Even if a business’ assets (such as buildings, equipment, and vehicles) remain undamaged by an extreme weather event, these events can lead to productivity loss Examples may be seen in agriculture and supply-chain issues. For example, of the nearly $150 billion in estimated damages from California’s 2018 wildfires, approximately 60 percent were indirect losses caused by disrupted economic activity. Climate Finance | João Amaro de Matos 17 Physical Risks: Impacts Households and real estate assets are also at risk. Property damage is the most immediate source of risk, and as home equity represents almost a third of US wealth, property damage or loss can have significant repercussions on the US economy. Natural disasters are also associated with an increase in credit card debt, debt collection, mortgage delinquency, and foreclosure. Households that are already financially unstable or who exist in underserved communities tend to experience these problems most acutely, and are also most likely to live in places that will feel the worst impacts of climate change. Climate Finance | João Amaro de Matos 18 Physical Risks: Impacts Local governments will face notable challenges from climate-related physical change as well. This can involve the risk of destruction of large-scale community infrastructure such as roads, bridges, and public buildings that must be replaced, and impacts on municipal budgets. Climate Finance | João Amaro de Matos 19 Physical Risks: Impacts Research has shown that climate change can increase the likelihood of local budget deficits and scarce resources. A 2022 study by scholars affiliated with Resources for the Future (RFF) found that California wildfires between 1990 and 2015 caused a long- term increase in local government spending and had a negative and significant impact on municipal budgets. Climate Finance | João Amaro de Matos 20 Physical Risks: Impacts Insurance providers may have to contend with losses as they pay out many large claims after natural disasters. Insurance is designed under the assumption that risks are predictable and that only a portion of those paying premiums will file claims at one time. As a larger portion of people and properties are likely to be affected by natural disasters in the future, changing risks and payout structures could cause major problems and, down the road, make insuring types of risk unaffordable for customers and/or impractical for insurers. Notably, about 95 percent of flood insurance in the United States is provided by the federal government through the National Flood Insurance Program (NFIP), often at a subsidized rate; the risk is deemed uninsurable by private insurers at rates affordable to typical households. However, major storms in recent years have driven the NFIP deficit to over $20 billion, prompting calls for reform. Climate Finance | João Amaro de Matos 21 Transition Risk Limiting further climate change will require significant changes to the global energy system, other greenhouse gas-emitting activities, and throughout the economy. The risks that accompany an uncertain path to a decarbonized economy are called transition risks. Climate Finance | João Amaro de Matos 22 Transition Risk How intense transition risk is, and where it will be felt the most, will be influenced by both government policy action (or inaction) to drive mitigation and the potentially changing expectations of the private sector—including investors—about future policy actions. These forces can contribute to transition risk via both underinvesting and investing too quickly in low- vs high-emitting activities when the profitability of business models depends on uncertain public policy and customer demand. Climate Finance | João Amaro de Matos 23 Transition Risk: Impacts Businesses may suffer from significant losses in the transition to net- zero emissions if their production or business models rely on greenhouse gas-intensive raw materials or processes. Among other considerations, businesses face the risk of their assets becoming “stranded.” Climate Finance | João Amaro de Matos 24 Transition Risk: Impacts Stranded assets are durable assets that may become unusable or prematurely decommissioned due to policy or market changes after a company has made an initial investment. For example, a company that builds an expensive power plant with the intention of recouping costs over the next few decades may later encounter regulations that make the plant unprofitable, rendering the asset “stranded” as the company can no longer recoup its initial costs as expected. Climate Finance | João Amaro de Matos 25 Transition Risk: Impacts Local governments can face significant transition risk if their finances are built around industries, such as oil and gas production and refining, that emit substantial greenhouse gases. A 2022 RFF working paper, for example, found that fossil fuels are responsible for approximately $85.2 billion in revenue each year for US municipalities, states, and tribes. And although revenue streams for fossil fuel communities are expected to dwindle both with and without future climate action, the uncertain nature of the low-carbon transition poses a further risk for communities that have historically relied on these funds to support infrastructure projects, education, and public health. Climate Finance | João Amaro de Matos 26  Transition Risk: Investment Global climate financial investment flows almost doubled in the last decade (compound annual growth rate 7%) CPI, 2022 Climate Finance | João Amaro de Matos 27  Transition Risk: Investment But still need to grow a lot to meet estimated needs by 2050 CPI, 2022 Climate Finance | João Amaro de Matos 28 Implications Climate Finance | João Amaro de Matos 29 Implications for financial sector and the public The impacts of physical and transitional risk range from profit losses and higher default risks for individual companies and investors to broad concerns over the stability of the system and burden on the public. This section details those impacts. Climate Finance | João Amaro de Matos 30 Implication: Higher Cost of Capital When a municipality faces severe infrastructure damage from a natural disaster, or when a company suffers from major profit losses in the energy transition, the likelihood of it defaulting on its debt or declaring bankruptcy increases. Considering these higher default risks, investors often demand a higher return on the investment and increase the at-risk borrower’s cost of raising capital. The degree of this increase depends on investor knowledge about the borrower’s climate risk exposure and the borrower’s actions to mitigate these risks. Climate Finance | João Amaro de Matos 31 Implication: Higher Cost of Capital Recent studies show that climate-related impacts on the cost of capital are already emerging. Municipalities hit by one or more hurricanes saw their municipal debts downgraded by rating agencies, and those with more sea level rise exposure are paying higher yields, especially on long-term bonds. Similarly, firms with higher carbon emissions may also need to provide higher returns on their stocks, consistent with lower investor demand for stocks of these companies. Climate Finance | João Amaro de Matos 32 Implication: Systemic Risk and Stability In finance, systemic risk refers to a broad risk of failure across the financial system. Such failure can arise from one major shock leading to a series of cascading failures within the financial system, or different parts of the financial system facing highly correlated risks. The 2008 financial crisis is a case in point where initial problems with mortgage-backed securities were amplified and spread by financial institutions. Climate Finance | João Amaro de Matos 33 Implication: Systemic Risk and Stability Climate risk is generally considered to be a systemic risk that is difficult to diversify away from within financial markets. Systemic risks are risks that affect the entire market or a broad sector of the economy, making it challenging to reduce exposure through diversification alone. Climate risks, such as extreme weather events, regulatory changes, or shifts in market preferences, can impact multiple industries, geographies, and asset classes simultaneously Climate Finance | João Amaro de Matos 34 Implication: Systemic Risk and Stability A few reasons why climate risk is typically seen as non-diversifiable: Correlation across assets: Climate risks can affect different types of assets and sectors simultaneously, leading to a high correlation of their returns. Market wide impacts: Climate risks can affect factors such as economic growth, inflation, interest rates, investor sentiment, and consumer behaviour. Interconnectedness: Climate risks can have interconnected effects across different regions and countries (supply chains). Common exposures: Climate risks can be shared by multiple market participants due to shared dependencies on common resources or factors affected by climate change. Climate Finance | João Amaro de Matos 35 Implication: Systemic Risk and Stability Climate change has the potential to trigger failures such as the 2008 crisis, as recognized by the Financial Stability Oversight Council (FSOC), the US Commodity Futures Trading Commission (CFTC), and others. Its broad impacts are further complicated by the deep uncertainties about the climate’s future, which hinders financial markets’ ability to price assets to properly reflect the relevant risks. Surveys show that financial professionals believe climate risks are underevaluated in asset prices. Climate Finance | João Amaro de Matos 36 Implication: Systemic Risk and Stability As a result, prices of a large class of assets could be sensitive to major updates in climate science, extreme weather events, and changes in climate policy. These sensitivities increase the possibility for disorderly price adjustments and spillover effects to other financial markets and the flow of goods and services. However, the timescale of climate change might allow sufficient time for assets to adjust given the typical investment horizon. Climate Finance | João Amaro de Matos 37 Implication: Burden on the Public Climate risks carry ramifications for the general public, including those who are not active financial market participants. Investments from pension funds and retirement savings are subject to the same risks as other investors. Furthermore, taxpayer dollars are at stake through the federal government’s role as the main provider of mortgage guarantees, flood insurance, crop insurance, disaster aid, and other social programs, and as the insurer of last resort to the financial sector in extreme events such as the 2008 financial crisis. In addition, if climate-related financial risks lead to a general economic downturn, millions will suffer from significant welfare losses and economic hardship. Climate Finance | João Amaro de Matos 38 Assessment and Management Climate Finance | João Amaro de Matos 39 Ways to assess climate financial risk A key policy option to lower both transition and physical risks is to implement governmental carbon pricing and similar climate policies consistent with national mitigation goals that facilitate orderly capital flow toward sustainable economic activities. However, firms, investors, financial regulators, and other groups still need proper knowledge of their exposure to both types of risks to properly manage them. That is, once new policies are in place, climate change will still occur, and the future path of those policies cannot be known with certainty. This next section covers financial market policies that might support sound assessment of climate financial risks by different entities. Climate Finance | João Amaro de Matos 40 Ways to assess: Disclosure Disclosure is the process by which an entity reports its assets, liabilities, and risks. Financial regulators across the world generally require disclosures of key financial information from public companies to help investors make informed decisions. In a climate context, this could include greenhouse gas emissions (both direct and in its supply chain), exposure to climate impacts such as flooding and wildfires, and management practices to address physical and transition risks. As the climate changes, these metrics are becoming increasingly relevant for investment decisions; For example, an investor in a state with stringent climate policies should be less inclined to invest in a business with relatively high carbon emissions. Climate Finance | João Amaro de Matos 41 Ways to assess: Disclosure In the United States, the Securities and Exchange Commission (SEC) announced a landmark proposal in March 2022 that would require public companies to disclosure their climate-related financial risk. Most would have to disclose their greenhouse gas emissions, requiring significant changes in the “environmental, social, and governance” (ESG) disclosure framework from US companies. For more on the SEC climate disclosure rule, read this Resources blog series that breaks down the proposed rule in detail. Climate Finance | João Amaro de Matos 42 Ways to assess: Disclosure International institutions have also set up similar protocols to measure climate risk. The European Union’s Sustainable Finance Disclosure Regulation, which has been in effect since March 2021, provides an avenue for investors to analyse investment funds’ environmental sustainability measures. Climate Finance | João Amaro de Matos 43 Ways to assess: Disclosure Some of the most widely used standards for measuring climate commitments and climate-related risks of companies are spearheaded by international nonprofit organizations. The Corporate Climate Responsibility Monitor, for example, assesses the integrity and transparency of climate pledges. Other groups, such as the Task Force on Climate-related Financial Disclosures, the Sustainability Accounting Standards Board, and the International Sustainability Standards Board, are working to accurately measure companies’ climate commitments and investment decisions. Climate Finance | João Amaro de Matos 44 Ways to assess: Risk Management The principles of risk management Financial risk management can be described in terms of three activities: Identifying risk Measuring risk Controlling risk These actions combine to form the process of managing risk. But “making predictions is hard, especially about the future.” Where are we headed in terms of climate change? Climate Finance | João Amaro de Matos 45 Broad Risk Measurement Approaches In principle, conventional measurements of risk could be adapted to assess climate-related financial risk, as the analysis of climate-related impacts, at both micro and macro level, is not fundamentally different from standard scenario analyses or stress tests. In practice, however, the range of impact uncertainties, time horizon inconsistencies, and limitations in the availability of historical data on the relationship of climate to traditional financial risks, in addition to a limited ability of the past to act as a guide for future developments, render climate risk measurement complex and its outputs less reliable as risk estimators. Among the risk measurement processes currently being applied, some more prominent and conventional practices include: Broad Risk Measurement Approaches Climate risk scores or ratings Climate risk scores (including heat maps) rate the climate risk exposure of assets, companies, portfolios, or even countries. They combine a risk classification scheme with a set of grading criteria to assign a quality score to exposures according to their classification. The grading criteria used within these approaches can be based on qualitative or quantitative factors. Climate risk scores can help assess the relative climate exposure of existing and prospective credit intermediation. Climate risk rating methodologies and criteria across banks and external parties exhibit a range of approaches, often developed with highly granular data, enabling them to be location-specific, and incorporate supply chain and company-specific information. However, climate risk ratings may exhibit more biases compared to similar approaches used in other contexts, in the absence of data on smaller counterparties and short data histories. Broad Risk Measurement Approaches Scenario Analysis Climate scenario analysis is a forward-looking projection of risk outcomes that is typically conducted in four steps: 1. Identify physical and transition risk scenarios; 2. Link the impacts of scenarios to financial risks; 3. Assess counterparty and/or sector sensitivities to those risks; and 4. Extrapolate the impacts of those sensitivities to calculate an aggregate measure of exposure and potential losses. Scenario analysis can be performed at different levels of granularity to identify impacts on individual exposures or on portfolios. By examining the effects of a wide range of plausible scenarios, scenario analysis can also assist in quantifying tail risks and can clarify the uncertainties inherent to climate-related risks. For the purposes of climate-related risks, scenario analyses tend to be longer-term in scope and used to evaluate the potential implications of climate risk drivers on financial exposures. Broad Risk Measurement Approaches Stress Testing Stress testing is a specific subset of scenario analysis, typically used to evaluate a financial institution’s near-term resiliency to economic shocks, often through a capital adequacy target. Typically, when considering solvency, there are two types of stress tests: macro prudential, which measure how financial shocks affect a financial system and may trigger systemic risk, and micro prudential, which evaluate an individual financial institution’s solvency given its portfolio risks. Climate stress testing evaluates the effects of severe but plausible climate scenarios on the resiliency of financial institutions or systems. However, the uncertainty inherent in longer-dated assessments and the limited predictive power of historical observations to describe future climate-economic relationships render estimates of capital shortfall (or other measures of resiliency) less reliable than those of conventional stress tests employed by supervisors and banks to evaluate resiliency Broad Risk Measurement Approaches Stress Testing The Network for Greening the Financial System (NGFS), a network of several dozen central banks and financial supervisors, has issued official guidance on climate scenario analysis for financial regulators. As of spring 2022, adopters of climate stress testing include the Netherlands, France, the European Central Bank, Canada, Australia, and the United Kingdom. US financial regulators, such as the Office of the Comptroller of the Currency (OCC) and the Federal Reserve, are also developing principles and infrastructure for climate stress testing. Climate Finance | João Amaro de Matos 50 Broad Risk Measurement Approaches Stress Testing Existing climate stress tests face several major challenges. For instance, the accuracy of the findings is limited by the availability and quality of firm-level data on physical risk factors and carbon intensity, which is not consistently reported at present. Further research is needed to refine modelling over a long-time horizon and to improve the plausibility and relevance of the scenarios. Climate Finance | João Amaro de Matos 51 Broad Risk Measurement Approaches Stress Testing and Scenario Analysis Climate risk scenario analyses, including stress testing and sensitivity analysis, are comprehensive assessments of the impact of macroeconomic and financial variables derived from climate-economy models. Because these scenarios are based on projections of possible future states of the world, they incorporate forward-looking information that can complement historical data. They aim at quantifying the potential financial impacts that banks or the financial system may face by comparing a baseline scenario against scenarios that reflect varying degrees of risk arising from climate change. In their current use, climate-related scenario analyses differ from traditional macroeconomic stress testing in terms of their scope, time frame and use of results. Broad Risk Measurement Approaches Stress Testing and Scenario Analysis Main differences between macroeconomic stress testing and climate scenario analysis: Risk Macroeconomic Climate-related risks Scope Elements of the profit and To date focus more on loss statement and selected exposures balance sheet Time frame Two to five years Short, middle, long term (over decades) Current use of risk Used in a regulatory To understand and assessment exercise context, e.g. for estimating evaluate the potential capital needs and planning impact on a risk profile capital management and strategy due to climate-related risk and raise awareness at financial institutions Broad Risk Measurement Approaches Sensitivity Analysis Sensitivity analysis is also a specific subset of scenario analysis that is used to evaluate the effect of a specific variable on economic outcomes. In these analyses, one parameter is altered across multiple scenario runs to observe the range of scenario outputs that result from changes in that parameter. In certain cases, several parameters can be changed simultaneously to observe interactions among parameters. Sensitivity analysis has often been used in transition risk evaluation to assess potential effects of a specific climate-related policy on economic outcomes, particularly in research settings to evaluate the range of economic impacts from the implementation of a carbon tax. Given the uncertainties noted above with scenario analyses, a climate sensitivity analysis may be a useful tool for risk decision-makers to understand the range of potential climate impacts. Broad Risk Measurement Approaches Climate Value-at-Risk Climate value-at-risk (VaR) assessments apply the traditional VaR framework to gauge the impacts of climate change on financial institutions’ balance sheets. Specifically, these forward-looking, portfolio-level metrics quantify the impacts of climate change on the value of financial assets over a given time horizon at a given probability under particular climate scenarios. Climate Risk Management Overview The combined economic and financial impacts associated with climate change may give rise to considerable future losses. Against this background, an effective risk management framework should have three goals: first, to identify material climate risk drivers and their transmission channels; second, to map and measure climate-related exposures and any area of risk concentration; and third, to translate climate-related risks into quantifiable financial risk metrics. Building on a discussion of conceptual issues related to climate- related financial risk measurement, we provide an overview of measurement methodologies currently employed or developed.