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Climate Finance Zacharias Sautner Frankfurt School of Finance & Management
Climate FinanceZacharias Sautner
Frankfurt School of Finance & Management
Source: Ed Hawkins. °C. Difference from annual mean, 1970-2000
Source: https://climate.nasa.gov/climate_resources/24/graphic-the-relentless-rise-of-carbon-dioxide/2
Source: https://earthobservatory.nasa.gov/features/CarbonCycle/page5.php 3
4
100 firms account for 71% of global industrial GHG emissions!
Source: CDP Carbon Majors Report 2017, Examples5
Cumulative distribution of CO2 emissions (S&P 500, 2016)
Source: Ilhan, Sautner, and Vilkov (2019)
All firms withemissionsdata in CDP Top 20
Cumulative distribution of CO2 emissions (S&P 500, 2016)
Source: Ilhan, Sautner, and Vilkov (2019)
Top 20 firmswithemissionsdata in CDP
Neurath Power Station, Germany, RWE, Fuel: Lignite (Brown Coal)
32 million tons of CO2 (2018)
Paris Agreement 2015 (COP 21)
9
10
WHY CLIMATE FINANCE?
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Paris Agreement 2015 (COP 21)
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A third of oil reserves, half of gas reserves and over 80% of coal reserves should remain unused
from 2010 to 2050 to meet the 2 °C target.
Source: McGlade, Christophe, and Paul Ekins, 2015, The geographical distribution of fossil fuels unused when limiting global warming to 2 °C, Nature 517, 187–190. 13
Climate change will have a major impact on financial markets.
Financial markets will have a major impact on climate change.
WE CAN HELP!14
Climate risk is challenging• Can adversely affect asset values, especially for long-term
investors• Is difficult to price and hedge
– Systematic nature – Lack of disclosure by portfolio firms – Difficulty in finding suitable hedging instruments
• Can also provide potential opportunities
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A brief look at some current work• Climate risks and institutional investing
– Krueger, Sautner, and Starks 2019
• Climate risks and financial markets– Ilhan, Sautner, and Vilkov 2019– Bolton and Kacperczyk 2019
• Climate risks and corporate disclosure– Ilhan, Krueger, Sautner, and Starks 2019
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A brief look at some current work• Climate risks and institutional investing
– Krueger, Sautner, and Starks 2019
• Climate risks and financial markets– Ilhan, Sautner, and Vilkov 2019– Bolton and Kacperczyk 2019
• Climate risks and corporate disclosure– Krueger, Sautner, and Starks 2019
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This paper• Survey of a broad base of institutional investors• Elicit these investors’ views and actions related to climate
risks • 439 respondents
– Global respondent group– 1/3 hold executive-level positions – 48 from institutions with >$100bn in AuM
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Generalizability, response bias• Possibly biased toward investors with high awareness of
climate risks / higher credentials in climate-risk management
• Views and actions of such investors particularly important– More likely to shape corporate climate policies and to
guide future practices of integrating climate issues into investment management
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0%
5%
10%
15%
20%
25%
30%
35%
40%
None Up to 1 degree Up to 2 degrees Up to 3 degrees More than 3degrees
Do not know
All Regions North America Continental Europe United Kingdom Rest of world
Investors’ climate expectations4 in 10 expect a rise that exceeds the Paris target!
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Financial risk Operatingrisk
Governancerisk Social risk Climate risk
Otherenvironmenta
l riskPercentage Top Risk 51% 15% 12% 11% 10% 4%Mean Ranking 2.2 2.9 3.3 3.7 4.0 4.6
0%
10%
20%
30%
40%
50%
Comparative importance of risks% respondents that rank each risk as most important
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3.8
3.5
3.8
3.3
3.4
3.5
3.6
3.7
3.8
3.9
Regulatory risk Physical risk Technological risk
Financial materiality of climate risk(1=Not at all important, 5=very important)
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Climate-risk horizonOver what time horizons, if any, do you expect these risks to materialize?
0%
10%
20%
30%
40%
50%
60%
Already today <2 years 2 to 5 years 5 to 10 years 10 to 25 years >25 years Never
Regulatory risk Physcial risk Technological risk
Climate risks have started materializing, especially regulatory risks
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Motivation for incorporating climate risks• Financial motives
– Higher returns– Lower risk (overall, tail)
• Nonfinancial motives– Preferences managers (Hong and Kostovetsky, 2012)– Insider-initiated philanthropy (Benabou and Tirole,
2010)• Others
– Regulatory requirements, protection of reputation, peer pressure
THESE ARE NOT MUTUALLY EXCLUSIVE 24
21%
23%
24%
25%
27%
28%
30%
Reduces tail risk
Reflects asset owners' preferences
Reduces overall portfolio risk
Is beneficial to investment returns
Is a legal obligation/fiduciary duty
Is a moral/ethical obligation
Protects our reputation
Top 7 motivations
THESE ARE NOT MUTUALLY EXCLUSIVE
Investor motivations to incorporate climate risks into investment process
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4%
7%
20%
23%
24%
25%
25%
26%
26%
29%
32%
34%
35%
38%
0% 5% 10% 15% 20% 25% 30% 35% 40%
OtherNone
DivestmentReducing stranded asset risk
Negative/exclusionary screeningHedging against climate risk
Shareholder proposalsUse of third-party ESG ratings
Firm valuation models that incorporate climate riskReducing carbon footprint of portfolio firms
ESG integrationGeneral portfolio diversification
Analyzing stranded asset riskAnalyzing carbon footprint of portfolio firms
Approaches taken to incorporate climate risk management in the investment process
Industry has taken first steps towards managing climate risks
But: two most basic approaches taken by <40%Divestment least frequently used approach
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More risk-management approaches by investors:• Who view climate risks as more material• With medium or long-term investment horizons• Who manage a higher proportion of their portfolios under
ESG principles• Who have been incorporating climate risks into their
investment decisions longer
Cross-sectional analysis of number of risk management approaches taken
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1%
16%
18%
19%
20%
29.6%
29.8%
30.0%
32%
43%
0% 5% 10% 15% 20% 25% 30% 35% 40% 45%
Other
None
Legal action against management on climate-risk issues
Voting against re-election of any board directors due to climate-risk issues
Publicly criticizing management on climate-risk issues
Questioning management on a conference call about climate-risk issues
Submitting shareholder proposals on climate-risk issues
Voting against management on proposals over climate-risk issues at theannual meeting
Proposing specific actions to management on climate-risk issues
Holding discussions with management regarding the financial implicationsof climate risks
Shareholder engagement on climate
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More shareholder engagement channels by investors:• Who view climate risks as more material• Who believe climate risks will materialize sooner • With more assets under management• Who manage a higher proportion of their portfolios under
ESG principles
Cross-sectional analysis of number of shareholder engagement channels used
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Pricing of climate risks• Climate risks can have a large impact on equity markets
– Bansal, Ochoa, and Kiku, 2017; Daniel, Litterman, and Wagner 2017; Litterman 2011
• Markets may be unable to correctly value them– Andersen, Bolton, and Samama 2016; Hong, Li, and Xu
2017
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Perceptions of climate-risk pricing
Industry
Valuations much
too high
Valuations somewhat too high
Valuations more or less
correct
Valuations somewhat
too low
Valuations much
too lowOil □ □ □ □ □Natural gas □ □ □ □ □Renewable energy □ □ □ □ □Nuclear energy □ □ □ □ □Electric utilities □ □ □ □ □…. □ □ □ □ □
D1: To what extent do equity valuations of firms in different industries reflect the risks and opportunities related to climate change?
□ Relatively confident □ More or less confident □ Not very confident
D2: How confident are you about your assessment in the previous question?
+2 -2
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Perceptions of climate-risk pricing
Industry Mean score STD
Relative industry
misvaluation
Percentage with score of +2 (much too
high)
Percentage with score of -
2 (much too low)
Mean Score (Confident
respondents)(1) (2) (3) (4) (5) (6)
Oil 0.52 1.03 37% 17% 3% 0.59Automotive (traditional) 0.48 0.94 25% 14% 2% 0.53Electric util ities 0.47 0.91 25% 13% 3% 0.48Information Technology 0.47 0.98 23% 16% 3% 0.50Insurance 0.46 0.91 21% 14% 1% 0.39Natural gas 0.44 0.91 17% 11% 2% 0.51Coastal real estate 0.43 0.96 13% 14% 3% 0.43Gas util ities 0.40 0.94 6% 11% 4% 0.38Transportation 0.40 0.92 4% 12% 3% 0.37….Mean (Across All Industries) 0.38 12% 3% 0.41
Mean valuation score > 0--> Valuations are somewhat too high, but overvaluation seems modest
Oil and traditional automotive most overvalued
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25.1%
21.3%
16.7%
11.9% 11.7%10.5%
0%
5%
10%
15%
20%
25%
30%
Coal producers Unconventionaloil producers
Conventional oilproducers
Natural gasproducers
Iron and steelproducers
Conventionalelectricityproducers
Percentage of respondents that believe that stranded asset risk is "very high" in the industry
Perceptions of stranded asset risks
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Perceptions of investment opportunities
Top 15 responses to open question; larger font = more frequently named 34
A brief look at some current work• Climate risks and institutional investing
– Krueger, Sautner, and Starks 2019
• Climate risks and financial markets– Ilhan, Sautner, and Vilkov 2019– Bolton and Kacperczyk 2019
• Climate risks and corporate disclosure– Ilhan, Krueger, Sautner, and Starks 2019
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This paper• Shows that higher carbon emissions increase firms’ tail risk• Increased regulation needed to meet the Paris Agreement
– Regulatory climate risks likely most severe for firms with large carbon emissions: “carbon risks“
• Political uncertainty about regulation affects asset prices (Pastor and Veronesi 2012; Kelly, Pastor, and Veronesi 2016; Koijen, Philipson, and Uhlig 2016).
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Carbon emissions and tail risk• Regulatory changes can have jump-like effects on asset prices.
– Fukushima Disaster (2011) and German nuclear plants closure:
– Major German utilities: -40% in 6 months.• Downward jumps can also be triggered by carbon risks.• We directly estimate the effects of carbon emissions on left-tail
risk of S&P 500 firms, estimated from OTM put options.
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Measures and data: Carbon emissions• Carbon emissions data from CDP.
– CDP is supported by institutional signatories with 100+$ trillion in assets under management.
• Reporting to CDP is voluntary, so need to account for potential selection bias.
• CDP data is widely used by institutional investors and ESG data providers (MSCI ESG Research, Bloomberg, Sustainalytics).
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Carbon emission typesThree sources of carbon emissions from a company’s operations. • Scope 1: Direct emissions from production.• Scope 2: Indirect emissions from consumption of purchased
electricity, heat, or steam. • Scope 3: Other indirect emissions from the production of
purchased materials, product use, waste disposal, outsourced activities, etc.
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Effect of emissions on tail risk
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Effect of attention to global warming
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Paris Agreement and tail risk
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A brief look at some current work• Climate risks and institutional investing
– Krueger, Sautner, and Starks 2019
• Climate risks and financial markets– Ilhan, Sautner, and Vilkov 2019– Bolton and Kacperczyk 2019
• Climate risks and corporate disclosure– Ilhan, Krueger, Sautner, and Starks 2019
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This paper• Shows that carbon risk affects the cross-section of U.S.
stock returns.• Investors seek compensation for holding the stocks of high
CO2 emitters.• It seems to be firm-level rather than industry-level
emissions that matter the most for investors.
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Carbon emissions and stock returns
45
Some other related work• Hsu, Li, and Tsou (2019): Highly polluting firms are more exposed to
environmental regulation risk and have higher returns.• Görgen et al. (2019): Construct a carbon‐risk factor which enhances
the explanatory power of common factor models. • Engle et al. (2019): Construct an index of climate news and develop
a dynamic portfolio strategy to hedges risk with respect to climate change news.
• Chava (2014): Firms with higher carbon emissions have higher costs of capital.
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A brief look at some current work• Climate risks and institutional investing
– Krueger, Sautner, and Starks 2019
• Climate risks and financial markets– Ilhan, Sautner, and Vilkov 2019– Bolton and Kacperczyk 2019
• Climate risks and corporate disclosure– Ilhan, Krueger, Sautner, and Starks 2019
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This paper• Surveys institutional investors about climate-related
disclosures by firms.• High-quality information on climate risks needed for
investment decisions and correct pricing of climate risks. • Disclosure on climate risks is also essential for regulatory
efforts to protect financial stability (Goldstein and Yang 2017).
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Current disclosure insufficient
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“to develop consistent, comparable, reliable and clear disclosure around the carbon intensity of different assets”
(Mark Carney, Governor, Bank of England)
“consistent and comparable corporate disclosure of material climate issues is critical [and]
investors require better climate disclosure“
(Anne Stausboll, former CEO, CalPERS)
“The only surprise […] is how hard it is to get the data […] I
think it will take years to get good data from the majority of
companies we are invested in.” (Yngve Slyngstad, CEO, NBIM)
Importance of climate risk disclosureCompared to reporting on financial information
4%
18%
51%
18%
10%
0%
10%
20%
30%
40%
50%
60%
Much lessimportant
Less important Equally important More important Much moreimportant 50
Quality of climate risk disclosure
0% 5% 10% 15% 20% 25% 30%
Management discussions on climate risk are not sufficientlyprecise
Firm-level quantitative information on climate risk is notsufficiently precise
Standardized and mandatory reporting on climate risk isnecessary
There should be more standardization across markets inclimate-related financial disclosure
Standardized disclosure tools and guidelines are currentlynot available
Mandatory disclosure forms are not sufficiently informativeregarding climate risk
Investors should demand that portfolio firms disclose theirexposure to climate risk
% with who “strongly agree”
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Climate risk disclosure and mispricing• Theory predicts a link between climate mispricing and
disclosure (Daniel, Litterman, and Wagner 2017). • Investors’ opinions on the quality of current climate reporting are
related to the perceived underpricing of climate risks. – Respondents who believe that reporting is lacking see more
mispricing in current equity valuations. • Consistent with Michael R. Bloomberg, Chair of the TCFD
– “Increasing transparency makes markets more efficient, and economies more stable and resilient.”
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Many open research questions• Pricing of climate risks, financial stability• Hedging instruments (what, how)• Disclosure (what, how)• Corporate governance (compensation, ownership)• Reallocation of capital flows (where from and to)• Financing instruments
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Thank [email protected]
