Green Finance

13.01.2021

Research Responsibilities

ESG, or Environmental, Social, and Governance, has become a hot topic recently. In this article I summarize what I have learned about environmental risks from various sources, and provide my thoughts on academic research focusing on green finance. These thoughts reflect my limited exposure to the subject.  

Environmental Risks

Environmental disasters can be understood conceptually as having two extremes in terms of their causes. One cause is mostly natural, while the other is the result of human behavior. An example of the former is an earthquake, and an example of the latter is the radioactive contamination resulting from nuclear power plants. The incidents in Chernobyl, Ukraine in 1986, and in Fukushima, Japan, in 2011, caused catastrophic damage. Another example of the latter is an oil spill. Such spills occurred frequently in the last century, especially in 1991 during the Gulf War. A recent incident was caused by British Petroleum (BP) in the Gulf of Mexico in 2010.

Most environmental disasters exist between two extremes of a wide spectrum. Wildlife poaching and excessive deforestation have resulted in huge losses in biodiversity and the deterioration of the ecosystem, upon which human welfare relies. Scientists have depicted a bleak picture for the near future, and called for immediate action. “It is not about saving our planet. It is about saving ourselves,” said BBC broadcaster and natural historian Sir David Attenborough in 2020.

Widespread environmental damage caused by human activity has been traced to the greenhouse effect of carbon dioxide emission. The atmospheric concentration of carbon dioxide has increased 45 percent from 280 parts-per-million (ppm) in 1750, when the industrial revolution began, to 415 ppm in 2019.  Much of the rise has been attributed to the combustion of fossil fuels (coal, petroleum and natural gas). The signatory nations of the Paris Agreement have been working on research, development, and deployment of green (low-carbon energy) technologies around the clock in order to achieve the goal of carbon neutrality, or net-zero, by 2050, to keep global warming at bay.

Green finance

Continued environmental pollution is one example of market failure. The traditional view of dealing with market failures is to rely on government through regulations and taxes. Problems like carbon dioxide emissions will need to be solved by the governments of virtually all the world’s nations working collectively. The challenges are obvious, as green technologies are costly to develop, and different nations are in different stages of development, and in different positions in the worldwide production chain, so the incentive for a free ride is high. Most industrialized nations have pledged to achieve net-zero emissions by 2050. China, the largest carbon-emitting nation, also recently promised to reach net-zero by 2060. But the US, the second largest nation in terms of carbon emissions, has been wavering in its membership with the Paris Agreement and the nation has not made a commitment towards achieving carbon neutrality. 

The job of reducing carbon emissions has been left to corporate executives. Fortunately, some of them are conscientious about environmental issues, and have voluntarily adopted costly green technologies which may generate short-term losses. Many corporate executives are forward-looking enough to understand that green technologies are the future. They realize that a penalty for carbon emissions will be established sooner or later, and that investment is irreversible or partially irreversible. Many companies are making investments in green technologies even though they are not profitable at the current regulatory settings.

Financial institutions are playing an increasingly important role in promoting green technologies. Insurance companies suffer directly from catastrophic environmental disasters. Investment companies such as mutual funds and hedge funds are holding nontrivial shares of the so-called stranded assets which are vulnerable to the potential future regulatory changes related to environment protection. Financial institutions are in advantageous positions in driving green technology, as many of their top executives also sit on the boards of directors of manufacturing companies, where they can exert direct influence on investments to ensure they are socially responsible. The transition to green technology often requires financing, and green bonds and loans have been the brightest points of the primary fixed-income markets in recent years, although their share is still small.

Green finance research

Until recently, green finance research by finance academics remained “an inconvenient void” (Hong, Karolyi and Scheinkman 2020). In economics, Nordhaus (1977) started his pioneering work on the carbon-dioxide problem in mid-1970s, and created a subfield of economics known as environmental economics. This was eventually recognized by mainstream economics with the awarding of the 2018 Nobel Prize. Finance researchers, however, had by and large been watching from the sidelines. In 2017, the editors of The Review of Financial Studies, one of the top-three finance journals, called for a special issue on climate finance in a Registered Reports (RR) format.[1] It drew 106 submissions, nine of which were selected by the editors based on the review committee’s recommendations.[2]

A bulk of the emergent green finance research focuses on issues related to hedging environmental risks. The subject ranges from optimal portfolio decisions to derivative trading with added environmental risk factors. That’s no surprise, as this is where financial economists do their best work, and these subjects are the low-hanging fruits among all the potential ones. While environmental risks have special features that are not usually taken note of in existing theory, the framework already exists, so it’s conceptually straightforward to crack the problems, although these problems are still technically challenging.

One strand of green finance research addresses a classic question in empirical asset pricing literature. In terms of financial assets, is environmental risk priced so that investors who bear higher risks will earn higher returns? The results are mixed, as can be imagined. First, they may depend on the sample period, as the question is tantamount to when the environmental risks have been recognized by the market. Second, they may also depend on which type of technology is regarded to be riskier: green technology and brown (dirty) technology, with regard to the uncertainty of green technology policies implemented by governments.  

There might be some dimensions in which environmental risks do not resemble other financial risks. Rational expectations of the ESG movement now could not have been formed decades ago. Sorting out the conceptual differences is important before cranking out empirical results.

There are many unexplored research areas in green finance, especially ones with normative features, like those in environmental economics. Most financial economists working on the empirical side used to document what happened in the past as passive observers. In order to exert influence on the real world and to sway corporate decisions towards adopting green technologies, we will need to think more actively on modeling discount factors that take the future evolution of carbon emission prices into account. These research areas may require us to get outside our comfort zones and to think outside the box. 

There has been a wide range of applied research into green finance by practitioners. Various ESG-scoring systems have been designed by different institutions. Academic researchers are in an impartial position to design green finance criteria to consolidate and reconcile distinct scores. Such consolidation and reconciliation require rigorous research to support them. Incentive compatible mechanisms are also essential in order to weed out “greenwashing,” a term for opportunistic behavior which takes advantage of green finance schemes.   

Conclusions    

In short, green finance has everything to do with economics and finance. Green finance research not only provides an opportunity for us to expand our research scope, it is also an inescapable responsibility. The Department of Finance at HKUST is proud to be making its contribution to this important area that benefits society at large.  

“Financial institutions are playing an increasingly important role in promoting green technologies,” says Prof Zhang Chu, Head of the Department of Finance and Director of the Center for Investing, HKUST Business School.

References

Attenborough, D. 2020, David Attenborough: A Life on Our Planet, BBC Television.
Hong, H., Karolyi, G. A. and Scheinkman, J. 2020, Climate Finance.The Review of Financial Studies, 33, 1011-1023.
Nordhaus,W. D., 1977. Economic growth and climate: The carbon-dioxide problem. American Economic Review 67, 341–46.
Nordhaus, W. D., 2019. Climate change: The ultimate challenge for economics. American Economic Review 109, 1991–2014.
Weitzman, M. L. 2009. On modeling and interpreting the economics of catastrophic climate change. Review of Economics and Statistics 91:1–19.

 

 

張處

Head, Professor
Finance