Carbon Risk Management (CARIMA)
‘Carbon Risks‘ and ’Financed Emissions‘ of financial securities and portfolios – quantification, management, and reporting based on capital market data
Climate change is a fact. The awareness for global climate risks of most governments worldwide has already led to various legislation and regulation, which promote the development of the economy towards a “Green Economy”. At the same time, the awareness for environmentally friendly investments of several capital investors increases steadily. Right now, a huge amount of assets is reallocated – from investments in the “Brown Economy” to investments in the “Green Economy”. Both developments have far-reaching and currently hard to predict consequences for the economy and lead to massively changing and ever more volatile assets. An often cited example thereof are “stranded assets”, which even might result in the risk for a financial market bubble, the so-called “carbon bubble”. Therefore, it is of elementary importance for all financial market actors to adequately quantify, manage, and report the opportunities and risks that arise with regard to the transition of the economy towards a “Green Economy”. The Chair of Finance and Banking of the Faculty of Business Administration and Economics of the University of Augsburg undertakes this task since 2015 within the scope of the research area “Carbon Risk Management” (CARIMA). A capital market based procedure is developed that allows for the quantification, management, and reporting of carbon risks for companies and respective financial securities and portfolios. The foundation is build by a Carbon Risk Factor BMG, which mirrors “carbon induced” risks and opportunities for potentially all financial securities and portfolios.
Climate change and its impacts
Climate change is a fact. In recent years, this has been verified by different scientific work. The Intergovernmental Panel on Climate Change (IPCC) is concerned with the scientific foundation of climate change, its potential impacts, and potential measures for adaptation and damage limitation. The reports of the 1st, 2nd, and 3rd working group of the IPCC affirm that climate change is primarily caused by greenhouse gas emissions (see IPCC (2014)). Those emissions have increased significantly since preindustrial times due to economic and population growth (see IPCC (2014)). The impacts of climate change are manifold and unforeseeable in their appearance and intensity: besides direct financial losses due to extreme physical weather events, such as heat waves, droughts, and hurricanes, there arise indirect financial losses due to the transition of the economy towards a “Green Economy”. Stern (2007) estimates yearly losses to be at least 5 percent of global gross domestic product, if global warming is going to increase by 5 to 6 degrees Celsius by the end of this century.
Worldwide regulatory measures for the containment of climate change
The climate conference in Paris in 2015 and the thereof resulting ratified climate agreement of the participating 195 nations asks for concrete and comprehensive climate protection measures of all countries in the world. By this, it is aimed at limiting the global annual average temperature to less than 2 degrees Celsius above preindustrial levels (2° target) (see UN FCCC (2015)). Governments act in different ways to reach this target. The EU thus established the Emissions Trading Scheme (ETS) (see European Commission (n.d.)), the United States of America passed the Clean Air Act, that regulates air emissions (see EPA (n.d.)). Besides, emissions of power plants should be reduced (Clean Power Plan of the USA, EPA (2016)). The various measures of decarbonization show that the transition process towards a “Green Economy” is in full progress.
Impacts of the decarbonization on the financial world
The transition process of the economy towards a „Green Economy“ has far-reaching consequences for the financial sector. With the decarbonization of the economy result, for example, “stranded assets”, i.e. financial assets which lose significant value due to environmental measures and action in climate policy. The currently still high prices of financial assets lead to the danger of the existence or emergence of a new financial bubble in form of the “carbon bubble” (see Carbon Tracker Initiative (2013)). Furthermore, companies have to take into account that investors pay increasingly attention to the environmental compatibility of their investments (see, e.g., the Portfolio Decarbonization Coalition (PDC), Sullivan/Petrovic/Fischer (2015)). These new trends urge financial market actors to adequately quantify and manage risks induced by climate change for the future. The transition process of the economy affects potentially all companies and corresponding financial assets, such as stocks, credits, corporate bonds, and funds, which eventually finance the CO2-emissions of companies (“financed emissions”).
Under carbon risks we subsume all financial opportunities and risks for companies and the corresponding financial securities and portfolios, which appear in connection with the transition process of the economy towards a “Green Economy”. Our aim is to develop a capital market based method that makes the quantification, management, and reporting of those carbon risks possible. In this way, among others, the financial impacts should be estimated, which occur if a company sticks to emission-intensive strategies, whereas the economy transforms itself towards a “low carbon economy” (see 2° Investing Initiative (2015)) – and vice versa.
Carbon Risk Factor BMG
We quantify carbon risk with a Carbon Risk Factor “Brown-Minus-Green” (BMG). This factor should support all financial market actors in quantifying, managing, and reporting of carbon risks. The Carbon Risk Factor BMG consists, among others, of CO2-emissions (and equivalents), since they are one of the primary criteria for regulation. Moreover, further indicators for the adaptability of companies to the transition process in the economy are adopted, for example the awareness for climate change, targets for emissions reduction and measures to increase energy efficiency. For the construction of the factor we follow the approach of Fama/French (1993) and Carhart (1997). We build on the fundamentals of nobel laureats in capital markets research, such as the Capital Asset Pricing Model (Sharpe (1964), Lintner (1965) and Mossin (1966)), the Portfolio Selection Theory (Markowitz (1952)) and the Option Pricing Theory (Black/Scholes (1973) and Merton (1973)).
Research and practice
The project CARIMA, sponsored by the German Federal Ministry of Education and Research, should not only close existing gaps in research. CARIMA should also support potentially all individuals and institutions to face these new economic risks and opportunities properly – and recognize them justly in the first instance, respectively. For this reason, we collaborate with our practice partner, the Verein für Umweltmanagement und Nachhaltigkeit in Finanzinstitutionen e.V. (VfU). We use the dialogue with all areas of the financial industry, regulatory authorities, governments, and rating agencies. By this continuous exchange with the financial practice and by parallel publications in journals we are going to make the concept of the Carbon Risk Factor BMG transparent and open to access, so that all financial market participants can profit from it.