Week 1 Flashcards
What is meant by carbon being a stock problem
- the issue is about accumulation of carbon in the atmosphere and it is a global negative externalitiy
- idea of the carbon budget reinforces this idea
what is the carbon budget ?
to limit warming to 1.5oC with an 83% probability a max total amount of 300gt of CO2 can be emitted as of 2020 (IPCC)
What does the IEA estimate yearly global CO2 emissions from human activity to be ?
40 gt
When will the carbon budget be exhausted?
at the current rate in less than 6 yrs
What are some of the general issues about climate damages
disproportionately effecting the poor
- dont have the financial capacity to absorb the damages
- uninsured against climate physical risk
- international community is v slow to respond to the change
Honduras had 2x hurricanes Eta and Iota how much of the GDP did it cause in losses
20% - $5b
in 2020 their GDP contracted by 9%
What are reinsuring companies?
insurance companies that deal with some physical risks and damages
v large AUM globally exposed - make them exposed to CC risk
What did the Swiss Re Insitute predict about GDP is no action is taken?
cc will impact 48 countries represeting 90% of the world economy
there will be a 20% loss in world GDP if no action is taken
What does the wrold economic forum risk perception survey 2021-2022 say are the top 3 risks
- climate action failure
- extreme weather
- biodiversity loss
WEF risks ranking on a global scale - what are top three in the following periods
0-2 yrs
2-5 yrs
5-10 yrs - list as many as you can of the top 5
0-2
extreme weather
livelihood crisis
Climate action failure
2-5
Climate action failure
extreme weather
social cohesion erosion
5-10
climate action failure
extreme weather
biodiversity loss
natural resource crisis
human environmental damage
What are NDCs
an outcome of the Paris 2015 agreement
an agreement by all signatories to act on climate change and make a contribution
even with best case scenario with full implementation of tagets and net zero targets of long term pledges and NDCs we are off target with a warming projected between 1.5-2.4oc
Why is Paris seen to be a turning point
new approach
- inclusiveness
- bottom up rather than top down - NDCs
- participation by sub-national institutions and organisations like coalitions of municipalities, business, and financial institutions
Despite the fact it was imperfect - transformed the global approach to GHG emissions - more being done information wise for investors
What is the portfolio decarbonisation coalition
investor action and climate change
when it comes to cc we are all players not spectators
criticised Cop 21 for cheap talk and a lack of enforcement pushing hard policies
What are some of the criticisms of the INDCs submitted for COP 21
- Emission reduction target vary a lot in size
- they are not legally binding - no real implication if they don’t reach the target
- GHG/GDP - eg India, if they increase coal and increase GDP there emissions will not be reflected with this measure as they both go up
- different reference years and periods for implementation
What is the Inflation Reduction Act
US government commiting to subsidise green activities like green energy and green investment
material impact on investors
What are the finanical risks associated with physical risks
- global warming leads to lower productivity
- 14% drop in labor supply on days with max temp of 30oc in exposed industries
- greater natural disaster risks - flood, wildfire etc.
What are some simple ideas for the financial risks of transition risks
regulatory and technological risks
chaning social norms
political risks - mass migration caused by cc
When and Who did a survey on insitutional investors
Krueger, Sautner and Starks
March, 2020
What did Krueger, Sautner and Starks find in the top 7 motivations for incorporating climate risks in the investment process that are key?
- benefical to investment returns (idea of doing well by doing good)
- reduce overall portfolio risks
-reduced tail risk
other ideas - ESG reputation and also another part of fiduciary duty etc.
From the KSS study what was more important physical or transition risk?
transition - higher wieght on regulatory and technological risks
How many ii investors already believe that climate risks are materialising according to KSS?
75%
From KSS how many asset managers already analyse the carbon footprint of their portfolio firms?
38%
What is the argument for divestment and what are some organisations that support it?
Divestment is rising (KSS)
two different interpretations
- moral imperative - don’t want to hold these companies that produce carbon emissions
- divestment for hedging reasons
350.org advocates for divestment
a risk management approach makes sense
What percentage of all stocks do the large ii own
25%
what are the large ii that own all the stocks
black rock
vanguard
statestreet
fidelity
Example of an activist fund?
Engine Number 1 - proposal for alterantive directors to b put on the board for Exon
What is Mark Carneys phrase and what does it mean?
the tragedy of the horizon
shifts in our climate bring profound implications for insurers, financial stability and the economy
the current issues pale in comparison of what is to come
cc is the tragedy of the horizon - beyond the horizon of
- the business cycle
- the political cycle
- the horizon of technocratic authorities like central banks who are bound by their mandates
insurers response to physical risks can have a very real consequence and pose acute public policy problems
an abrupt resolution of the ToH is a financial stability risk
time is an important element - the less time there is the more risks there are with the process as there is less time to implement change and the rate of change will have to be faster
Why is cc a risk-management problem
accounting for cliamte change risks means three things for investors
1. investors will seek to hedge cc risks by reducing their exposure to their risk
- investors will demand compensation for holding this risk
- investors will engage with companies to induce them to reduce the risk
reducing exposure to carbon transition risk is a form of divestment is justified on prudential risk management
What are transition risks from (general idea)
there is a tight link between emissions and temperature changes
- but this link is not 1:1
decarbonisation commitments
the stated objective is to reduce carbon emissions sufficiently to avoid an average temperature risk of more than 1.5 degree celsius by 2050
these commitments generate transition risks for corporations
what are the two dimensions of transition risk
at what cost will carbon emissions decline, will they decline fast enough?
how do investors percpetions and expectations about carbon risk evolve?
How is risk perceived in finance and what it it
it is the idea of the unknown something that is different to what we expected. not about loosing money
risk should be compensated with some expected return
What is the issue with natural offsets?
in order to stay within the 1.5oc we need to get negative carbon emissions however the natural assets have been compromised and do not have sufficient capacity to get to the negatives
What is CAPM and why is it useful
it is a model to think about the compensation for risk based on portfolio theory that mixes asset that end up with a portfolio frontier where there is an optimum portfolio of risky assets that maximises the tradeoff between risky assets and expected return
however investors have different preferences of market portfolio and risk free assets therefore are generally choose to be along the line for the combination
what is a beta? what relationship does it have with diversification ? what does it mean when it is high?
the beta of the market is the market risk - compensation should be relative to the beta - every asset should be proportionately rewarded relative to the beta risk
through diversification you go from total risk to beta risk
with a well diversified portfolio - idosyncratic risk becomes less impactful - only thing that matters is market risk
the higher the beta the higher the compensation associated with the risk
Can you explain what the Fama-McBeth 2-step procedure is to test CAPM
- regress excess returns of asset i on the excess return of the market - time-series regression
= delivers the beta for each asset I
to form a portfolio of stocks decile portfolios based on the betas - 10% highest and lowest beta eg. - regress the average return on the beta and an intercept - cross-sectional regressions
if the CAPM is true then the intercept alpha should - the risk free rate
How do you know if a portfolio is under or over priced using a CAPM graph
CAPM says that no asset should be mispriced, everyone should be holding the market portfolio
the higher the beta the lower the price - higher the beta the more risk
if the portfolio is under the line it is over priced
if the portfolio is over the line it is under-priced
In what way does CAPM fail?
average portfolio returns deivate systematically from the security market line
the higher the beta of the portfolio the higher the deveisation
What are the two potential explanations for CAPM failure? and what do we need to do after each explanation
- Assets are mispriced - money is left on the table
- if this is true we can build a trading strategy and make money - Need more than one risk factor other than the market to explain the asset returns
- If this is true need to look at other risk factors that predict returns - Arbitrage pricing theory - Fama-French
- or look at stock characteristics that mimic risk factors - Daniel and Titman, 1997
What are the LT and ST risks for carbon as a risk factor
LONG
the LEVEL of the firms emissions determines their distance from net neutrality - idea of the size of the transition
SHORT
the CHANGE in emissions determines firm’s progress towards net neturality
What does the rate of reduction of carbon emissions depend on?
technological progress
- expected cash floes the cheaper it is to produce alternative energy
policy tightness
- Lula vs Bolansaro - thinking about risk premia
uncertain about each element increases transition risk - the cash flow effect
What do investor perceptions about carbon risk depend on?
socio-economic environment
stronger preferences for greening the economy amplify transition risk - discount rate effect
How do you know that long term and short term carbon risks are different?
there is low correlation for the two measures across scopes
this suggests that they are two independent risk factors
If a compny had high emissions in the past..
they will likely have high emissions today - slow moving variable - takes time to decarbonise
What is the relationship between market cap and emissions
largest market cap dont tend to have higher emissions
emissions from production - companies like JP Morgan don’t do much production
important to think about industry variation and not just within but also across industry
