Ep. 35, Sustainability Conference on Capital Finance

Key Concepts:

• Climate Risk (Political, Physical, Transition)
• Quantifying Risk (Investor Behavior, Regulation, Financial Stability)
• Carbon Burden (Present Value of Social Costs of Future Carbon Emissions)
• Scope 1 Emissions (Direct Emissions)
• Scope 2 Emissions (Indirect Emissions from Electricity Production)
• Net Zero Economy

1. Climate Risk and its Measurement:

• Main Topic: Johannes Strobble's keynote address focused on the risks climate change poses to assets and how to measure them.
• Types of Risk:
  • Political Risk: How policies reacting to climate change affect production and asset returns (e.g., impact of policies on farm profitability and stock returns).
  • Physical Risk: Extreme weather events (due to climate change) disrupting production and affecting stock returns.
  • Transition Risk: The speed of transition to a net-zero economy and its differential impact on firms (some benefit from faster transition, others do not).
• Measurement Challenges: Difficult due to the short time series of reliable climate data. Finance relies on long time series, which are lacking for recent climate changes. Confidence in risk assessment is a key challenge.

2. Quantifying Risk: Rationale and Applications:

• Investor Behavior: Quantifying risk helps investors understand the relative riskiness of different assets (e.g., comparing oil companies to renewable energy companies). Investors need to know which is riskier.
• Regulation (Federal Reserve):
  • The Federal Reserve regulates the banking system and must assess the risk in banks' loan portfolios.
  • Firm loans: Banks lend to firms with different climate risks and the Fed must ensure banks are not making loans that are too risky
  • Banks collect insured deposits and the Fed must ensure the loan side isn't too risky.
  • Bank failures can cause contagions and destabilize financial markets (as seen in the 2007 financial crisis).
  • Mortgage loan portfolios: Properties on the coasts are exposed to sea-level rise, requiring the Fed to ensure banks recognize these risks in loan decisions.

3. The Concept of Carbon Burden:

• Definition: The present value of social costs of future carbon emissions.
• Calculation:
  1. Estimate a firm's emissions (e.g., GM).
  2. Use scope one emissions which are direct emissions from the use of fossil fuels.
  3. Apply a cost per ton of emissions (in dollars).
  4. Compute the present value of all future emission costs.
• Importance of Scope One Emissions: Using scope one emissions avoids double-counting, especially when aggregating the carbon burden across firms. Scope 2 includes emissions from electricity production, which would double-count the electricity company's scope 1 emissions.

4. Logical Connections and Arguments:

• The discussion moves from the general measurement of climate risk to the specific concept of carbon burden, showing how these risks can be quantified and attributed to individual firms.
• The need to quantify risk is tied to investor behavior, regulatory requirements, and the stability of the financial system.
• The emphasis on scope one emissions highlights the importance of accurate and consistent accounting methods in environmental finance.

5. Notable Quotes and Attribution:

• Not directly quoted, but the core idea is expressed as: "How do policy decisions affect stock returns?" and "Banks collect deposits from depositors and these deposits are insured and so the the Fed needs to make sure that the loan side of the bank uh is not too risky."

6. Technical Terms and Concepts:

• Climate Risk: Risks to assets arising from climate change (political, physical, transition).
• Scope One Emissions: Direct greenhouse gas emissions from sources owned or controlled by the reporting entity.
• Scope Two Emissions: Indirect greenhouse gas emissions from the generation of purchased electricity, steam, heating, and cooling consumed by the reporting entity.
• Net Zero Economy: An economy that achieves a balance between the greenhouse gases emitted and those taken out of the atmosphere.
• Carbon Burden: The total cost to society, in present value terms, of a company's carbon emissions.

7. Synthesis/Conclusion:

The conversation highlights the increasing importance of quantifying climate risk in financial decision-making and regulation. Properly measuring these risks is crucial for investors, regulators (like the Federal Reserve), and the overall stability of the financial system. The concept of carbon burden provides a tool for assessing the social costs of corporate emissions, emphasizing the need for accurate accounting methods (using scope one emissions) to avoid double-counting and ensure meaningful comparisons. The ability to quantify and manage climate-related financial risks is becoming essential for navigating the transition to a sustainable economy.