ISQD Published Papers

Authors: Oliver Tietjen, Kai Lessmann and Michael Pahle
Published in: Resource and Energy Economics, 2021
Tags: Carbon Pricing, Theory

Abstract: Cap-and-trade programs such as the European Union’s Emissions Trading System (EU ETS) expose firms to considerable risks, to which the firms can respond with hedging. We develop an intertemporal stochastic equilibrium model to analyze the implications of hedging by risk-averse firms. We show that the resulting time-varying risk premium depends on the size of the permit bank. Applying the model to the EU ETS, we find that hedging can lead to a U-shaped price path, because prices initially fall due to negative risk premiums and then rise as the hedging demand declines. The Market Stability Reserve (MSR) reduces the permit bank and thus, increases the hedging value of the permits. This offers an explanation for the recent price hike, but also implies that prices may decline in the future due to more negative risk premiums. In addition, we find higher permit cancellations through the MSR than previous analyses, which do not account for hedging. Read more.

Authors: Andrew McConnell, Boyan Yanovski, and Kai Lessmann
Published in: Climate Policy, 2021
Tags: Central Banking

Abstract: Central banks can play an important role in the transition towards a climate-neutral economy. This paper discusses different green monetary policy instruments along the dimensions of feasibility of implementation and impact on the transition process. We identify the inclusion of ‘brown’ collateral haircuts into a central bank’s collateralized lending framework as the most promising conduit of green monetary policy. The impact of such interventions on the real economy is then formally explored by extending a general equilibrium transition model to include a simple banking sector with central bank lending facilities and collateral adjustments. We find that both ‘brown’ collateral haircuts and ‘green hairgrowth’ increase carbon neutral investment while decreasing carbon intensive investment and emissions. Consequently, in addition to decreasing the exposure of the central bank balance sheet to climate-related risks, climate-based collateral adjustments have the potential of increasing the political feasibility of a timely transition to a carbon neutral economy by affecting emission levels. Despite ‘green hairgrowth’ having a stronger effect on investment and emissions, ‘brown’ collateral haircuts remain the recommended policy as the former is not necessarily ‘market neutral’ and thus cannot be broadly applied across central banks. Read more.

Authors: Michael Koetter, Felix Noth and Oliver Rehbein
Published in: Journal of Financial Intermediation, 2020
Tags: Physical Climate Risk, Corporate Governance, Banking, Empirical

Abstract: We show that local banks provide corporate recovery lending to firms affected by adverse regional macro shocks. Banks that reside in counties unaffected by the natural disaster that we specify as macro shock increase lending to firms inside affected counties by 3%. Firms domiciled in flooded counties, in turn, increase corporate borrowing by 16% if they are connected to banks in unaffected counties. We find no indication that recovery lending entails excessive risk-taking or rent-seeking. However, within the group of shock-exposed banks, those without access to geographically more diversified interbank markets exhibit more credit risk and less equity capital. Read more.

Authors: Alex Stomper and Tobias Geiger
Published as: PNAS Letter, 2020
Tags: Physical Climate Risk, Damage Functions, Macroeconomics, Econometrics

Abstract: The recent paper by Coronese et al. reports a rise in economic damages due to extreme natural disasters reported in the Emergency Events Database (EM-DAT). While Coronese et al.’s paper is timely and relevant, we have serious concerns regarding the analysis and the interpretation of the results. First, the dependent variable of Coronese et al.’s main model is, according to the definition in EM-DAT, a measure of capital stock (CS) damages, and CS data should therefore be used as a control variable. While CS data are contained in the Penn World Table (PWT), Coronese et al. instead used gross domestic product (GDP) data from the same source. Read more.

Authors: Claudia Lambert, Felix Noth, and Ulrich Schüwer
Published in: Review of Finance, 2019
Tags: Physical Climate Risk, Banking, Empirical

Abstract: This paper explores how banks react to an exogenous shock caused by Hurricane Katrina in 2005, and how the structure of the banking system affects economic development following the shock. Independent banks based in the disaster areas increase their risk-based capital ratios after the hurricane, while those that are part of a bank holding company on average do not. The effect on independent banks mainly comes from the subgroup of highly capitalized banks. These independent and highly capitalized banks increase their holdings in government securities and reduce their total loan exposures to non-financial firms, while also increasing new lending to these firms. With regard to local economic development, affected counties with a relatively large share of independent banks and relatively high average bank capital ratios show higher economic growth than other affected counties following the catastrophic event. Read more.

Authors: Felix Noth and Oliver Rehbein
Published in: Finance Research Letters, 2019
Tags: Physical Climate Risk, Corporate Governance, Empirical

Abstract: We investigate firm outcomes after a major flood in Germany in 2013. We robustly find that firms located in the disaster regions have significantly higher turnover, lower leverage, and higher cash in the period after 2013. We provide evidence that the effects stem from firms that already experienced a similar major disaster in 2002. Overall, our results document a positive net effect on firm performance in the direct aftermath of a natural disaster. Read more.

Authors: Xavier Giroud, Holger M. Mueller, Alex Stomper and Arne Westerkamp
Published in: The Review of Financial Studies, 2012
Tags: Physical Climate Risk, Corporate Governance, Banking, Empirical

Abstract: Based on a sample of highly leveraged Austrian ski hotels undergoing debt restructurings, we show that reducing a debt overhang leads to a significant improvement in operating performance. Changes in leverage in the debt restructurings are instrumented with Unexpected Snow, which captures the extent to which a ski hotel experienced unusually good or bad snow conditions prior to the debt restructuring. Unexpected Snow provides lending banks with the counterfactual of what would have been the ski hotel’s operating performance in the absence of strategic default, allowing them to distinguish between ski hotels that are in distress due to negative demand shocks (“liquidity defaulters”) and those that are in distress due to debt overhang (“strategic defaulters”). Read more.

ISQD Working Papers

Authors: Kai Lessmann and Matthias Kalkuhl
Latest Version: 2020 (CESifo Working Paper No. 8380)
Tags: Carbon Pricing, Banking

Abstract: Interest rates are central determinants of saving and investment decisions. Costly financial intermediation distort these price signals by creating a spread between the interest rates on deposits and loans with substantial effects on the supply of funds and the demand for credit. This study investigates how interest rate spreads affect climate policy in its ambition to shift capital from polluting to low-carbon sectors of the economy. To this end, we introduce financial intermediation costs in a dynamic general equilibrium climate policy model. We find that costly financial intermediation affects carbon emissions in various ways through a number of different channels. For low to moderate interest rate spreads, carbon emissions increase by up to 7 percent, in particular, because of lower investments into the capital intensive clean energy sector. For very high interest rate spreads, emissions fall because lower economic growth reduces carbon emissions. If a certain temperature target should be met, carbon prices have to be adjusted upwards by up to one third under the presence of capital market frictions. Read more.

Authors: Ottmar Edenhofer, Kai Lessmann and Ibrahim Tahri
Latest Version: 2021 (CESifo Working Paper No. 9269)
Tags: Theory, Asset Pricing

Abstract: Climate policy needs to set incentives for actors who face imperfect, distorted markets and large uncertainties about the costs and benefits of abatement. Investors price uncertain assets according to their expected return and risk (carbon beta). We study carbon pricing and financial incentives in a consumption-based asset pricing model distorted by technology spillover and timeinconsistency. We find that both distortions reduce the equilibrium asset return and delay investment in abatement. However, their effect on the carbon beta and risk premium of abatement can be decreasing (when innovation spillovers are not anticipated) or increasing (when climate policy is not credible). Efficiency can be restored by carbon pricing and financial incentives, implemented in our model by a regulator and by a long-term investment fund. The regulator commands carbon pricing and the fund provides subsidies to reduce technology costs or to boost investment returns. The investment subsidy creates a financial incentive that complements the carbon price. In this way the investment fund can support climate policy when the actions of the regulator fall short. These instruments must also consider the investment risk and the sequence of their implementation. The investment fund can then pave the way for carbon pricing in later periods by preventing a capital misallocation that would be too expensive to correct. Thus the investment fund improves the feasibility of ambitious carbon pricing. Read more.

Authors: Hendrik Schuldt and Kai Lessmann
Latest Version: 2021
Tags: Theory, Financial Frictions

Abstract: Climate policies such as carbon prices aim to increase the risk-adjusted returns of capital investment in green technologies vis-à-vis conventional fossil investment. The purpose of the financial sector is to channel capital flows from investors to projects offering the highest risk-adjusted returns. An efficient climate policy outcome thus relies on efficient financial markets. In reality, financial frictions such as bankruptcy costs and uncertainty about entrepreneurial success influence financial intermediation and can distort the transmission of climate policy. This study analyses the impact of emission taxes on mitigation and low-carbon investment in the presence of financial frictions. We employ a two sector (clean and dirty) environmental dynamic stochastic general equilibrium (E-DSGE) model with financial frictions. The model is calibrated to the Euro Area in 2017 and features differentiated financial characteristics among the sectors. We simulate the transition of the economy in line with the 2030 Climate Target Plan. We find that financial frictions decelerate the response of the economy to the carbon tax and the mitigation target will be missed by 11 percentage points. Moreover, the adverse effects of financial frictions increase if climate policy is delayed. We further identify a volume and a risk effect that drive the impact of a financial wealth shock and an uncertainty shockon emission intensity. Read more.

Authors: Boyan Yanovski, Kai Lessmann and Ibrahim Tahri
Latest Version: 2020
Tags: Portfolio Optimization

Abstract: We study how investments that require long-term financial commitments are affected by undiversifiable, uninsurable risk in the economic environment in the context of investor preferences characterized by decreasing absolute risk aversion and a desire for consumption smoothing. In our setting, if funds are committed long-term, they become unavailable in the short-term resulting in an increased exposure to shocks before maturity of the investment. Coupled with decreasing absolute risk aversion, this leads to an endogenous discounting of long-term projects. High perceived risk in the economic environment leads to low levels of long-term investment (short-termism). We also explore policy measures that can support long-term investment, in particular, during times of increased uncertainty. Read more.

Authors: Emilie Rosenlund Soysal and Kai Lessmann
Latest Version: 2020
Tags: Stranded Assets, Portfolio Optimization

Abstract: Diverging beliefs about the impact of climate policy on the value of fossil fuel assets can lead investors to different valuations of fossil fuel companies. This paper models the share price formation in a market where one group of investors systematically overestimate future prices, and explores how firms can maximise firm value through share repurchases by responding to changing investor beliefs. We find that the optimal buyback strategy reduces the impact of price volatility on share prices, i.e. the optimal response of the firm is to counteract price variations. When expectations to future prices drop, the optimal response is to buy back shares. Furthermore, we show that the optimal buyback strategy can lead to a persistent and higher share of investors who overestimate future share value compared to the case where the supply of shares are fixed. The result implies that buybacks can dampen price signals originating from fossil fuel divestment. In the light of substantial engagement in buyback programs observed in the US oil sector, divestment is unlikely to have had any significant effect on share prices or firm valuations in this sector. Read more.

Authors: Simon Baumgartner, Alex Stomper, Thomas Schober and Rudolf Winter-Ebmer
Latest Version: 2019
Tags: Physical Climate Risk, Corporate Governance, Banking, Empirical

Abstract: We show that banks’ equity capital buffers affect the risk-taking of firms in the banks’ vicinity. The analysis is based on a sample of small firms exposed to weather risk as a risk concerning the productivity of the firms’ employees. By using highly granular data, we can cleanly identify the baseline effect of the risk on the firms’ employment, as well as modulating effects. We find that, if local banks lack equity capital, the firms respond more strongly to the exogenous labor productivity risk by cutting their employment. Our results also highlight that banks’ equity capital buffers matter for economic adaptation to climate change and increased weather variability. Read more.

ISQD Policy Proposals

Author: Alex Stomper
Written in: 2021
Tags: Climate Policy, Real Estate, Carbon Taxation

Abstract: Hier wird ein Finanzierungsmodell vorgeschlagen, das auf staatlichen Förderungen zur energetischen Gebäudemodernisierung beruht, diese aber benutzt um ein hohes Volumen an privaten Investitionen zu mobilisieren. Statt massiver direkter Zuschüsse zu Modernisierungskosten, werden Förderungen vorgeschlagen, die über die Zeit hinweg ausbezahlt werden. Dabei kann ein wachsender CO2-Preis zugrunde gelegt werden. Mehr lesen.