Measuring and Managing Climate Risk

The traditional financial reporting model is deficient in two fundamental respects: (i) we set the cost of natural capital used by the business to zero; and (ii) we either under-emphasize or ignore accounting for externalities, both positive and negative, imposed by the business on other stakeholders. The objective of this class is explore one major aspect of natural capital and its attendant risks—related to climate. The focus is mostly on how companies, both in the U.S. and elsewhere, measure, disclose, govern and hence manage (or sometimes mis-manage) climate risk exposures. The Paris Agreement of 2015 was meant to mobilize a global response to the threat of climate change, amid growing concerns by scientific experts, as documented in a series of IPCC reports. Since the Paris agreement was signed, hundreds of firms have made net zero emissions promises. Regulators and the investment community has been pushing firms to evaluate their climate risk exposure and the impact thereof on the firm’s business model and value drivers. Having said that, integrating environmental risks into company and investment analysis is not easy. The data and disclosures underlying measurement of these risks are all over the place. The tools and metrics used in practice, such as carbon footprints to forward looking climate scenario analysis, range from snake oil to highly sophisticated scientific approaches aimed at understanding climate exposure of a firm or an asset management fund’s business. On the positive end of the spectrum, technological innovation has and will continue to give rise to many investment opportunities. Sustainable finance has exploded to cover low carbon funds, green bonds, sustainability linked debt and other securities designed to capture these opportunities. Many of these investment vehicles need careful scrutiny as financial and legal engineering and associated greenwashing is not uncommon. We hope to cover these issues and ask a few hard questions related to (i) how do firms and some state owned entities measure and manage climate risks; (ii) how should we consume trillion dollar forecasts of the costs and opportunities associated with climate change; (iii) should we trust a net zero pledge; (iv) how should we assess physical and transition risks for firm exposed to climate change; (v) how should we consume ESG reports and ESG data providers; (vi) will businesses manage to transform themselves enough to adapt to decarbonization challenge; (vii) do low carbon funds help or hurt; (viii) how should we think about climate related KPIs (key performance indicators) in financing and executive compensation contracts; and (ix) how might regulators and financial supervisors measure the impact of finance sector on climate and how might they address such impact. We will also take some time each week to address any topics that are in the financial press that bear on the subjects and the approach.