Professional Documents
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Advanced - Finance - 5
Advanced - Finance - 5
Advanced - Finance - 5
Advanced Finance
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Larry Fink
CEO of Blackrock
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Agenda
• Climate change risks and market efficiency
I Equity markets
• Green bonds
I Divestment
I Engagement
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Two types of climate risks
2. Transition risks
I Indirect effects from climate regulation, technological change
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Equity markets and climate change (1/3)
• Brown firms are more exposed to transition risk (e.g., from a sudden
increase in the carbon price)
I Holds for total emissions but not for emission intensity (?)
"We find that stocks of firms with higher total CO2 emissions (and changes in emissions)
earn higher returns, controlling for size, book-to-market, and other return predictors.
[...] Overall, our results are consistent with an interpretation that investors are already
demanding compensation for their exposure to carbon emission risk."
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Equity markets and climate change (2/3)
⇒ If brown firms are shunned by responsible investors, they
have to offer high returns to attract other investors
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Equity markets and climate change (3/3)
⇒ If investors don’t pay enough attention to climate risk, exposed
firms are overvalued and will have low returns in the future
• Hong et al. (2019) find that food stocks in countries ranked high on
drought risk have low earnings and low returns
• Glossner (2021) finds that stocks with an ESG scandal have more
such scandals and low returns going forward
• Choi et al. (2020) find that retail investors sell high-emission stocks
when it is hot
• Alok et al. (2020) find that fund managers in natural disaster zones
temporarily underweigh affected stocks
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Municipal bond and real estate markets
• Physical climate risks likely to matter most for assets that cannot
"escape" effects from climate change
• Municipal bonds
I In the U.S., municipalities issue their own bonds backed by local
taxes (and there is no federal bailout guarantee)
I Big market: $3.9 trillion USD of outstanding muni bonds in 2020
I Painter (2020) finds that munis from counties with larger expected
losses from sea-level rise have higher yields at issuance
• Real estate
I Bernstein et al. (2019) find that homes exposed to sea-level rise sell
for 7% less than otherwise comparable homes
I Baldauf et al. (2020) find that this effect is weaker in communities
in which skepticism in climate change is widespread
⇒ Green bond issuance exploded (as did the issuance of social and
sustainability bonds)
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Green bonds (2/4)
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Green bonds (3/4)
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Green bonds (4/4)
⇒ We expect green bonds to have lower yields to maturity (YTM)
compared to otherwise similar non-green bonds!
• A green bond comes with the constraint that the money must be
used for a green project
• If the green bond would not be cheaper, the issuer would prefer
issuing a regular bond without constraint
• Green bond investors are willing to lend at a lower rate since they
derive satisfaction (i.e., "nonpecuniary benefit") from knowing that
their money will be used for a green project
• Baker et al. (2018) find that yields on green bonds are 6 basis
points lower than yields of otherwise similar non-green bonds
⇒ One reason why firms may issue green bonds even if they were
not cheaper is the signal value (for environmental commitment)
• Flammer (2021) finds that stock returns and environmental
performance increase post-issuance
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ESG (1/2)
• Environmental, Social, and Governance (ESG) investing looks at
corporations’ environmental and social impacts alongside profit
• ESG investing in the U.S. has reached $17.1 trillion in 2020,
representing 33% of AuM (see US SIF 2020 trend report)
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Do YOU care about corporate externalities?
Question: Suppose you can buy a stock today that offers to pay you a
dividend of e10 in one year (and after this the firm closes). On top of
the dividend paid out to you, the firm may also donate money to a green
development project and/or cause environmental damages from pollution.
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Do investors care about corporate externalities?
• Bonnefon et al. (2019) run a very similar online experiment on
Amazon’s MTurk platform
• They find that participants are willing to pay $0.7 more ($0.9 less)
for a stock giving $1 more ($1 less) to charity
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Two strategies for environmentally responsible investors
1. Divestment
I Most ESG investment funds exclude firms with low-ESG scores (from
data providers such as MSCI or Sustainalytics)
2. Engagement
I Billionaire Chris Hohn, founder of the TCI hedge fund, launched the
Say on Climate campaign, rallying shareholders to force companies
to disclose their CO2 emissions
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Divestment (1/4)
E (rP ) − rF
SRP =
σP
I Portfolios that maximize the Sharpe ratio are efficient; i.e., they offer
the highest possible return for a given level of risk
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Reminder: Portfolio theory
• N assets; asset i has expected return of E (ri ), standard deviation of
σi , and correlation of return with asset j 6= i of ρij
• Let wi be the portfolio weight of (=fraction of wealth in) asset i
NB: portfolio weights sum to one; short-sale positions have wi < 0
N
E (rP ) = ∑ wi × E (ri )
i =1
N N
σP2 = ∑ ∑ wi × wj × σi σj ρij
i =1 j =1
N N N
= ∑ wi2 × σi2 + 2 × ∑ ∑ wi × wj × σi σj ρij .
i =1 i =1 j =i +1
NB: for a portfolio of two stocks we have σP2 = w12 σ12 + w22 σ22 + 2w1 w2 σ1 σ2 ρ12
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Quiz: Portfolio theory
1. What is σP ?
2. What is SRP ?
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Divestment (2/4)
• Capital Allocation Line (CAL) with and without divestment
• Sharpe ratio of efficient portfolios = slope of the CAL
ܧሺݎሻ
CAL with brown and green stocks
T T’
ݎி
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Divestment (3/4)
• How big are diversification/SR losses from divestment?
• Example: 1, 000 identical stocks with constant correlation
Rho = 10%
.6
.5
Sharpe ratio
Rho = 20%
.4 .3
.2
0 .2 .4 .6 .8 1
Fraction of excluded stocks
I To the extent that divestment does raise brown firms’ cost of capital,
green funds underperform brown funds (Hong and Kacperczyk, 2009)
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Engagement (1/2)
I Akey and Appel (2019) and Chu and Zhao (2019) find that target
firms reduce toxic chemical emissions
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Engagement (2/2)
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Sustainability data
• Carbon emissions
Carbon Disclosure Project, Trucost, MSCI, Sustainalytics, Thomson
Reuters, Bloomberg, ISS
• ESG rankings
MSCI, Sustainalytics, Bloomberg, RepRisk, Arabesque
• Corporate disclosures
Task Force on Climate-related Financial Disclosures (TCFD), Say on
Climate
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Conclusion
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