ISQD Working Papers

Climate Finance Intermediation: Interest Spread Effects in a Climate Policy Model

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.

Asset Pricing and the Carbon Beta of Externalities

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.

Financing the low-carbon transition: The impact of financial frictions on clean investment

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.

The Link between Short-Termism and Risk: Barriers to Investment in Long-Term Projects

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.

Share Repurchase under Diverging Beliefs about Carbon Risk

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.

Risk and Employment: Banking on Snow

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.