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Is the loss of biodiversity reflected in asset prices? How will climate change affect insurance markets? Would a carbon tax or a cap-and-trade system be more effective at reducing carbon emissions?
Researchers shared their work on these and other questions at the Sustainability Conference on Capital Finance, held February 27 and 28 at Stanford University. The conference, part of the Stanford Initiative on Business and Environmental Sustainability research conference series, was sponsored by Stanford Graduate School of Business and Stanford Doerr School of Sustainability. It is one of 10 conferences this year that are organized by the Business, Government and Society Initiative at the GSB. Monika Piazzesi, the Joan Kenney Professor of Economics, senior fellow at the Stanford Institute for Economic Policy Research, and professor, by courtesy, of finance at the Stanford Graduate School of Business, and Amit Seru, the Steven and Roberta Denning Professor of Finance,
senior fellow at the Hoover Institution and at the Stanford Institute for Economic Policy Research, co-led the conference.
For the keynote session, “Climate Finance: A Research Overview,” Johannes Stroebel, David S. Loeb Professor of Finance at New York University, outlined three prominent strands of research focused on interactions between economic activity and the health of the planet: the pricing of climate risk across asset classes, financial insights into climate regulation, and biodiversity risk.
“Financial economics has interesting insights to contribute to a better understanding of the economic effects of climate change,” Stroebel said.
In his discussion of the pricing of climate risk, Stroebel outlined research on two types of climate risk — physical risks, such as wildfires or rising sea levels, and transition risks, such as carbon taxes or changes in consumer preferences — and their effect on the valuation of assets. Some research has found recent evidence that climate risk is being priced into many asset classes, though it is not clear if these assets are priced appropriately. These questions are important because if, for example, the current valuation of homeowner insurance or real estate does not fully account for climate risks, a major repricing could occur in these markets. Historically, such episodes have involved reallocation of resources in the economy and, at times, financial instability that required policy interventions.
Finance can also provide insights into climate regulation, Stroebel said, helping determine the optimal levels and tools of regulation. On issues like carbon emissions, for example, financial economics researchers work alongside those in the physical and social sciences to estimate the social cost of carbon: the economic damages from emitting one additional ton of carbon dioxide. They use these estimates to evaluate different ways to regulate emissions — calculating, for example, whether a carbon tax or a cap-and-trade system would be more effective.
Stroebel emphasized that while biodiversity risk and climate change are conceptually distinct in how they impact economic activity, they are often studied by overlapping communities and exhibit important interactions. Biodiversity risks are particularly relevant for sectors such as agriculture, forestry, and pharmaceuticals. Recent research has developed news-based indices to track biodiversity risk by analyzing newspaper content. This approach begins by creating a biodiversity dictionary — comprising terms like “ecosystem” and “deforestation” — and then applies natural language processing techniques to quantify biodiversity-related news coverage. By linking this index to U.S. equity market data, researchers are able to measure firms’ or sectors’ exposure to biodiversity risk and examine whether this risk is reflected in asset prices. Early evidence suggests that biodiversity risks are beginning to influence U.S. equity valuations.
Over six conference sessions, researchers presented recent work or work in progress on climate finance, with other researchers offering a discussion of each presentation:
Incentives for green production
In a session titled “Climate Capitalists,” Kilian Huber, associate professor of economics at the University of Chicago, looked at what incentives could encourage firms to invest in green production methods.
One market-based approach to addressing climate change is sustainable investing. A growing strategy within this approach is to assign a higher cost of capital to high-emission investments compared to lower-emission ones, thereby encouraging firms to pursue greener projects. For this mechanism to be effective, however, firms with greater emissions must indeed face higher capital costs. To assess this, Huber and his coauthors analyze data from corporate earnings calls to estimate the cost of capital that firms actually apply. Their findings show that managers at high-emission firms tend to use higher discount rates for their investments. Additionally, within firms, managers assign higher costs of capital to divisions with greater pollution levels. Importantly, this “pollution premium” has been rising over time.
Vikrant Vig, William R. Timken Professor at the Stanford Graduate School of Business and senior fellow at the Stanford Institute for Economic Policy Research, noted that these findings are valuable for investors. However, in his discussion of the research, he emphasized that for the findings to inform policy, it is crucial to understand why managers assign these specific costs of capital to their projects. For instance, do the elevated costs reflect expectations about future carbon taxes, or are they a response to the growing influence of ESG investing? More broadly, Vig argued that assessing the quantitative significance of the cost of capital channel is key to evaluating its role in driving greener investments.
Can sustainable investing reduce emissions?
Another question about sustainable investing is whether it can encourage companies to move toward greener technologies — by lowering the cost of capital for green firms, for example. In a session titled “Asset Returns as Carbon Taxes,” Martin Schneider, professor of economics at Stanford, senior fellow at the Stanford Institute for Economic Policy Research, and professor, by courtesy, of finance at the Stanford Graduate School of Business, discussed whether this cost-of-capital approach could provide the same incentives as carbon taxes.
Schneider provided a general result about the equivalence of two types of taxation in a large class of economic models: a carbon tax and a capital tax that depends on the emission intensity of firms. Under a carbon tax, firms are taxed on the level of their carbon emissions. Under a capital tax, firms with higher emission intensities pay a higher cost of capital, because investors demand compensation for the capital tax. Both types of taxation lead to a greening of the economy. Quantitatively, the carbon tax is more effective, however. The reason is that the distribution of emission intensities in the economy is highly skewed: very few firms produce most of the emissions. To incentivize firms in the tail of the distribution to green their production, the capital tax and thus the cost of capital would have to be very high for these firms, much higher than existing estimates of the pollution premium, for example, by Huber in the earlier session.
Another driver of a high cost of capital for polluting firms is investor preference — specifically, when investors are reluctant to hold assets issued by dirtier companies. This mechanism relies on broad agreement among investors that high-emission investments are undesirable. In markets where such consensus is lacking, the mechanism breaks down, as investors indifferent to emissions would continue buying these stocks, preventing elevated returns from being sustained. Schneider emphasized that while green investing cannot fully replace carbon taxation, his model helps identify how it can be used most effectively. One promising strategy is for green investors to target highly polluting firms with strong potential to transition to cleaner production — such as those in the electricity sector. By lowering the cost of capital for cleaner firms in this sector, investors could meaningfully reduce overall emissions.
Schneider, along with Niels Gormsen, Neubauer Family Associate Professor of Finance and Fama Faculty Fellow at the University of Chicago, also explored practical approaches to implementing such a strategy, including structuring investment funds that would subsidize cleaner electricity firms, potentially by taking them private.
Responding to climate change uncertainty
Climate change introduces a lot of uncertainty into economic models. The possibility of unpredictable events – for example, a major technological innovation that helps alleviate the effects of climate change — can make it difficult to project how markets will evolve.
In his presentation, “Stochastic Responses and Valuation under Climate Change Uncertainty,” Lars Peter Hansen, David Rockefeller Distinguished Service Professor in Economics, Statistics and the Booth School of Business at the University of Chicago, looked at ways to quantify uncertainty. The research is part of a larger effort to explore the impact of uncertainty on private- and public-sector decision making.
In discussing the research, Ben Herbert, associate professor of finance at Stanford, said the techniques can help assess the tradeoff between capital investment and research and development (R&D).
For example, one challenge with models to assess the value of R&D is uncertainty about the accuracy of the information the model uses. If projections of economic output are too high, the value of R&D will be lower, since economies with less economic output have lower emissions. There is similar uncertainty about the success of the R&D efforts. The model Hansen discussed indicates that as long as some growth is projected, R&D remains a valuable investment.
Climate change and the property insurance market
As property owners find it increasingly difficult to obtain affordable insurance, financial economists trying to untangle how the property insurance market is reacting to climate change have been hampered by a lack of good data.
In a presentation titled “Property Insurance and Disaster Risk: New Evidence from Mortgage Escrow,” Ben Keys, Rowan Family Foundation Professor, professor of real estate, and professor of finance at the University of Pennsylvania, showed how he and his colleagues used loan-level data to solve this data challenge. They used ZIP code-level data on insurance expenditures to study how premiums have changed in the past decade. Their findings shed much-needed light on the dynamics of the property insurance market, said Juliane Begenau, associate professor of finance at the Stanford Graduate School of Business and Center Fellow at the Stanford Institute for Economic Policy Research, in response to the paper.
Among the findings: Property insurance premiums increased 15% from 2020 to 2023, much faster than inflation. The increases were concentrated in ZIP codes with the highest exposure to natural disasters, and rising reinsurance costs were a key driver. The researchers also found the first evidence that rising insurance premiums are being reflected in housing prices.
Modeling the interactions of biodiversity loss and the economy
Financial economics research in sustainability has tended to focus on climate change, but biodiversity — the variety of species on earth — is also a crucial component. Biodiversity helps support economic activity through provisioning services (providing raw materials) and supporting services, such as pollination and the provision of clean air and water. Biodiversity finance is a new field with many unanswered questions — and implications for policy.
In a presentation titled “The Economics of Biodiversity Loss,” Stefano Giglio, Frederic D. Wolfe Professor of Finance and Management at Yale University, discussed a flexible model for assessing the dynamics of biodiversity loss and how it interacts with the economy. Bard Harstad, David S. Lobel Professor in Business and Sustainability at the Graduate School of Business, professor of environmental social sciences, and professor, by courtesy, of economics at Stanford University, discussed the findings.
Giglio and his co-researchers modeled the effects of human land use on the interactions among species. The model predicts that biodiversity loss can lead to higher risks in the future, even if current losses are not large.
Do firms’ carbon emissions exceed their value?
Policymakers, companies, consumers and investors all have an interest in answering the question: How valuable are firms to society?
In a presentation titled “Carbon Burden,” Luke Taylor, John B. Neff Professor in Finance and professor of finance at the University of Pennsylvania, explained that by one measure, the U.S. carbon burden — the present value of social costs from future carbon emissions — is 131% of the total corporate equity value. The carbon burden exceeds the market capitalization for 77% of firms when looking at total emissions (including indirect emissions) and for 13% of firms based on direct emissions.
Carbon burden varies greatly across sectors, with utilities and the energy sector producing high levels of direct emission and sectors such as finance and healthcare producing lower levels.
Taylor said the point is not to demonize the corporate sector: Even firms with large carbon burdens may be providing valuable benefits to society.
In discussing the research, Antonio Coppola, assistant professor of finance at the Stanford Graduate School of Business and Center Fellow at the Stanford Institute for Economic Policy Research, noted that it has important implications for corporate governance since emissions could become a liability for companies in the future.