Video: Can the Tools of Finance Help Combat Climate Change?

I work on trying to understand the motivations and the drivers of investors’ preference for green investment. I try to understand how can investors use the financial insurance that they have access to better ensure themselves against potential climate change damages or damages from regulation of climate change. ‌

I think, by now, most people realize that climate change could have potentially very large implications for the economy, and financial markets can potentially play a role independently because they’re responsible for many activities that actually can have an effect on the climate. For example, they could facilitate a flow of resources from polluting production activities to green activities. Or they could also help with adaptation part—they could help us finance those activities that then help us protect against the damage from climate change. ‌

I think the problem is partly that the people that operate in financial markets are private investors, and climate change essentially is a big externality problem. It comes from a fundamental externality: when I pollute, I don’t internalize the full cost of my pollution. The biggest limitation of what financial markets can do ultimately links back to the fundamental problem of climate change, which is that any private investor doesn’t fully internalize their action. ‌

If you think about the role the financial markets can play in the transition to sustainable economy, it has to come from the fact that some types of investors are, in a sense, willing to pay a price to internalize the externality, and by paying a price, they can help the transition. The biggest limitation of the entire movement today it that it’s really been driven by a subset of investors. To the extent that there’s enough investors on the other side that don’t really care about climate change and they’re not internalizing it, and they’re willing to basically offset whatever demand comes from the green investors, then the effects will be a wash.‌

There are many ways in which financial markets can actually help the transition. One of them, probably the most direct one, is the cost of capital. If green investors are willing to pay more for green companies and less for polluting companies, this will make the cost of capital higher for polluting companies and lower for green companies, and, in theory, should spur further changes in investment. Now, in practice, we have a sense that this channel is not being very strong because we see that the price difference are pretty small. They don’t want to lose the six basis points or whatever it is for green bonds. That tells us that, again, there aren’t enough massive investors that are willing to invest in these green investments, but I think we’re moving in the right direction.‌

Even for those investors that say, “Oh, we’re very ethically motivated,” there’s a huge gradient in terms of how much they actually buy all these ESG investments. As long as the green investment is doing great, in a sense, the investors could think at the same time, “We’re doing well and we’re doing good. We’re saving the environment, but we’re also making money.” The moment that these investments are doing less well, then many investors, even those more ethically motivated, start pulling back, because for them, the pecuniary considerations are important. If investors get into these investments thinking they’re going to make money, they’re going to be disappointed in the future. I think they should get into this investment for the right reasons, which is, one, playing a role in trying to address the externality, and two, to have a portfolio which is insulated from climate scenarios, from climate damage.‌

When I buy house insurance against fire, for example, for my house, I am making an investment that, on average, is going to lose money—but I’m buying insurance. I think this product should be really seen as insurance more than just bought for purely speculative reasons, but that’s something that is not in the mindset of the average investor today. ‌

But we shouldn’t expect financial markets to be able to solve the entire problem. It needs to be complemented by political actions. For example, ultimately—if not now, then later on—we’re going to end up imposing a carbon tax or imposing some other type of system that forces this internalization onto all the economic agents. Well, when the carbon tax comes, you’re going to lose a lot of money, and it’s actually in your own interest to be the portfolio that doesn’t suffer so much once we actually have to recognize that we need to change our policy to face the climate problem. ‌

Very importantly, this political action has to happen on the global scale, because otherwise there’s going to be leakage. Otherwise, one policymaker is going introduce a carbon tax in a region, and production is going to move to wherever there’s no carbon tax. This needs to be not just dealt with by the political system, but needs to be coordinated globally. For me, the main long-term obstacle is simply going to be, do we have enough massive investors that are willing to make this green investment even at a price, even at a cost? That’s the big unknown. I think, for now, it’s not enough to push the transition.‌