What is Climate Risk in Finance?
Professor Paul Griffin says the phrase is key to lawsuits pushing fossil fuel firms to disclose their carbon footprint
Among the many risks that investors and creditors face on a regular basis, climate is a special case.
UC Davis Professor Paul Griffin and co-author Amy Meyers Jaffe explain in their recent paper that the financial risks surrounding fossil fuel companies and climate change are based on a high degree of complexity, uncertainty and ambiguity.
To understand this climate-finance recipe, analysts must factor in so many ingredients that it’s easy to lose sight of the final dish served to investors.
The financial model grows more complex when analysts mix in the many environmental variables related to climate change. As it boils down to the exact impacts from wide-scale climate events like warming surface temperatures, the risk becomes more uncertain. And it grows more ambiguous when fewer of the chefs can agree on the causes and effects.
Griffin and Jaffe define climate risk through three categories:
1. THE PHYSICAL ENVIRONMENT
A fossil fuel firm can be accountable in two ways for the physical and environmental effects of its carbon emissions.
“Threats to firm value from the firm’s past actions” is one, explain Griffin and Jaffe. If a company knew but didn’t disclose about its contributions to climate change, it could be vulnerable to litigation from investors or state and local governments, and that exposure can threaten the firm’s market value. Griffin details in The Conversation how Exxon Mobil recently bowed to this sort of pressure.
A company’s future operations and investments is a risk as well, since large firms often model future scenarios for their activities. They factor in potential regulatory policies—including climate legislation—and the company’s expected emissions. The results can be complex and highly inaccurate. Holding them accountable for this information also raises many legal, political and economic questions about balancing the public’s right to know against a company’s right to privacy over its plans.
Griffin calculates in a recent paper the steep costs for processing the additional information, which have not been not being taken into account before.
2. REGULATORY POLICY
Government regulations are another risk. Climate policies can have many uncertain outcomes for companies—some immediate and others drawn out over decades. As with anything climate related, the environmental consequences for exceeding a government’s cap on emissions can go well beyond the loss of return or market value. As those consequences gradually unfold through climate change, they would add more litigation exposure to firms as well.
3. OUTSIDE INVESTORS AND CREDITORS
For all these reasons and more, outside parties connected to the fate of fossil fuel companies may not have all the accurate and unbiased information they need when making investment decisions. This also adds to a firm’s climate risk.
Each of these categories of climate risk is dependent on scientific research, which tends to take a far broader snapshot and looks across much longer timelines than would an individual company with its relatively near-term business goals. Tracking down the scientific evidence that would tie specific carbon emissions to an individual company is yet another steep hurdle.
“The same science or analysis can also mean different things to different people,” says Griffin. “Hence we have climate science acceptors and deniers. This ambiguity creates market risk.”
SOLUTIONS TO CLIMATE RISK
In their paper, Griffin and Jaffe make the point that if climate risk can be traded in markets, those willing to take those risks will set the price, independent of their political leanings.
“Even a denier would likely want to protect himself from rising sea levels by buying climate change insurance,” says Griffin.
The two researchers have proposed five ways that fossil fuel firms could open up more about climate risks.