Corporate Finance and Climate Change Adaptation
For the last 15 years, I have worked on the microeconomics of climate change adaptation. So far, my best known work is my 2010 Climatopolis book and my 2021 Adapting to Climate Change book and my mortgage finance paper with Amine Ouazad that will be published by the Review of Financial Studies.
A theme throughout my work is that people and firms have strong personal incentives to adapt to emerging climate risks. So much work in the popular press hints that we are “passive victims” with little ability to protect ourselves from emerging risks. I reject this pessimism. Unlike in the case of reducing greenhouse gas emissions (mitigation) where there is a fundamental free-rider problem, risk averse people and firms seeking robust profit maximization strategies will search for solutions and market products to offset Mother Nature’s harder punches.
As aggregate demand for solutions increases, other for profit capitalists innovate to enhance our menu of adaptation strategies (see our 2017 paper). This dynamic game lowers the market price of adapting and allows even poor people to purchase air conditioners, cell phones and a vast set of other ways to protect themselves from rising heat, pollution and other challenges posed by climate change. Given that this is a complex logic chain, many young climate economists do not explore this. Why? First, this agenda is slightly politically incorrect because it optimistically argues that our standard of living will continue to improve. Second, young scholars in climate economics want to simplify and study “cause and effect” one equation systems (Does extreme heat lead chess players to make worse moves?). A dynamic Hayek style economy doesn’t offer such a clean way to write up the main results. In my 2020 LSE Lecture, I talk about how climate economic research actually helps to accelerate adaptation through the Paul Revere effect.
In my vision for how we will adapt to climate change, for profit firms play a key role. Think of Amazon. Is there any climate shock that could really injure that firm’s productivity? The firm’s profits soared during COVID in 2020 as everyone shopped on line. Firms that can cope with a crisis are rewarded without any transfers from the Biden Administration. As I talk about in my 2021 book, Amazon had strong incentives to research the quality of life dynamics in the cities it considered for its HQ2 headquarters. Such an office will be the home to its workers for decades. Amazon doesn’t want to pay excessive “combat pay” to such workers so it has strong incentives to choose cities where its workforce wants to live both today and in the year 2040!
I do not believe that Amazon has perfect foresight about quality of life in the year 2040 in Boston versus Phoenix and I bet that they consulted with climate science firms such as Jupiter about emerging risks in different areas. In my books, I argue that if a city’s quality of life is expected to deteriorate relative to its rivals in the coming decades then firms will migrate away from it or not move there. This fear of losing one’s tax base provides even Republican leaders with incentives to invest in resilience! Climate scientists routinely miss out on this point because they aren’t thinking about competition and equilibrium.
Corporate Finance and Adaptation
To adapt to climate change, firms will need to make new investments and thus will need access to finance. Which firms will foresee new challenges and new opportunities? At any point in time, what are the set of adaptation strategies that are available? How effective is each? What is the fixed cost and variable cost of launching each one? What is the firm’s cost of accessing capital to pay for these projects? What is the opportunity cost of pursuing a more resilient production process? This is the bare bones agenda for corporate finance and climate change resilience. If a CEO pursues the resilience agenda, will her shareholder board call her a “Chicken Little” who is worried too much or will they celebrate her desire to invest in robustness to protect the firms against worst case scenarios? If the firm does not invest in resilience such as redundant supply chains, can it hedge this risk through financial markets such as futures markets and insurance markets? Do such markets act as complement or a substitute for the firm’s investments in self-protection? Intuitively, in a flood zone —- a property owner can reduce her risk exposure by putting the home on stilts (self-protection) or buying a flood insurance policy. Which is “cheaper”?
A firm such as Amazon is in a unique situation to gain market share from climate change. The firm has great data on what consumers want and how these desires change. For example, the firm can track how product demand in Phoenix evolves when it is very hot in summer. Amazon can configure its supply chains to factor in resilience threats. Amazon’s deep pockets means that it is unlikely to face financing constraints. Amazon can issue debt at almost the same interest rate as the U.S government.
A for profit firm will invest in resilience (to offset Mother Nature’s punches) until the expected present discounted value marginal revenue of the investment equals the marginal cost. If the firm fails to make these investments and is exposed to increased climate shocks, shareholders will notice and they will nudge the CEO to be more pro-active. In this sense, even “behavioral” CEOs will face competitive adaptation pressure. In my 2021 book, I build on this point and argue that family owned firms could have sleepy nepotistic CEOs who ignore emerging threats. These firms are at risk as Mother Nature punches harder!
This creates an arbitrage opportunity for hedge funds that purchase such distressed assets and bring in better, adaptation friendly management to run the business.
So, I predict that increased climate shocks will reduce the count of family held firms and more professional managers will manage more of our economy. Larger firms tend to feature better managers who have better access to finance so that firms invest efficiency. An inefficiency could be costly if there are lumpy fixed cost climate resilience investments that would be quite effective in offsetting risk but they aren’t made because the firm is liquidity constrained. This is a simple example of how corporate consolidation and/or improvements in access to bank finance can accelerate adaptation.
In my new empirical research, I’m investigating commercial loan defaults in the aftermath of natural disasters. We are especially interested in whether small businesses and minority owned small businesses experience a higher loan default rate after disasters. This finding would have important implications for environmental justice as it would suggest that on average —- businesses handle shocks but that real economic incidence is borne by the “little guys”.
Climate Change adaptation raises exciting research possibilities at the intersection of management economics (see Nick Bloom’s work), climate change economics and corporate finance.
I want to see new research studying how banks will evaluate loan requests when borrowers want to use the loan to finance resilience investments. If the borrower can post collateral then this should be an easy decision by the bank. If the bank relies on backward looking AI algorithms , it may under-estimate the economic returns of such investment. In this case, a capitalist optimist would need to argue that if different lenders using different AI algorithms for making loans then some bank out there will be more optimistic about making such loans.