HEC Paris — M1 — Feb-Mar 2025

Advanced Finance

[#6] Climate Finance

Johan Hombert, Daniel Schmidt

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 Larry Fink
CEO of Blackrock

From the 2021 Letter to CEOs:

"No issue ranks higher than climate change on our clients’ lists of priorities.
[...] From January through November 2020, investors in mutual funds and
ETFs invested $288 billion globally in sustainable assets, a 96% increase
over the whole of 2019. I believe that this is the beginning of a long
but rapidly accelerating transition—one that will unfold over many years
and reshape asset prices of every type. We know that climate risk is
investment risk. But we also believe the climate transition presents
a historic investment opportunity."

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Blackrock accused of:
• abusing "collective power, including through proxy voting, to
pressure the coal producers"
• deceiving clients that non-ESG funds “would be dedicated solely to
enhancing shareholder value” while in fact advancing climate goals
2024 Letter to CEOs is toned down:
"I’m hearing more leaders talk about decarbonization and energy security
together under the joint banner of what you might call energy prag-
matism. [...] Even the most climate conscious [leaders] saw that their
long-term path to decarbonization will include hydrocarbons, albeit less of
them, for some time to come.”

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 Agenda
• Climate change risks and market efficiency

I Equity markets

I Municipal bond and real estate markets

• Green bonds (and related instruments)

• Socially responsible investment (SRI)

I ESG investing

I Divestment vs. engagement

I Carbon tax vs. climate finance

• Discussion of group assignment

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 Two types of climate risks

1. Physical climate risks

I Direct effects from increasing temperatures, droughts, sea-level rise,
natural disasters, etc.
I For example, coastal real estate is threatened by sea-level rise

⇒ Often far in the future; may not (yet) be efficiently priced

2. Transition risks
I Indirect effects from climate regulation, technological change

I For example, introduction of a carbon tax or development of an

efficient renewable energy source makes coal plants unprofitable
("stranded asset risk")

⇒ Very important today as many countries pledge to be carbon-

neutral by 2050

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 Equity markets and climate change (1/3)
⇒ If transition risk is priced, brown (dirty) firms should have higher
expected returns
• Brown firms are (presumably) more exposed to transition risk (e.g.,
from a sudden increase in the carbon price)
• Confirmed by Bolton and Kacperczyk (2020) and (2023):
I Stocks with high total emissions earn higher returns
(after controlling for known factors)
I Holds for total emissions but not for emission intensity (?)

"We find that stocks of firms with higher total CO2 emissions (and changes in emissions)
earn higher returns, controlling for size, book-to-market, and other return predictors.
[...] Overall, our results are consistent with an interpretation that investors are already
demanding compensation for their exposure to carbon emission risk."

• Zhang (2024) finds that the "carbon premium" is due to look-ahead

bias in emissions data
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 Equity markets and climate change (2/3)
⇒ If brown firms are shunned by responsible investors, they
have to offer high returns to attract other investors

• "Sin stocks" earn higher expected returns

(Hong and Kacperczyk, 2009)
• Example: Norwegian Oil Fund
I more than $1 trillion in AuM (world’s largest sovereign wealth fund)

I divested from 53 coal manufacturers in 2014

I further $10 billion divestment of fossil-fuel stocks announced in 2019

• Consistent evidence provided by Choi et al. (2021):

"We find that financial institutions around the world reduce their exposure to stocks
of high-emission industries after 2015 [...] In the presence of divestment, public high-
emission firms tend to experience lower price valuation ratios, but they increase capital
expenditure, research and development (R&D) expenses, and green innovation activities,
and reduce emissions resulting from their operations."

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 Equity markets and climate change (3/3)
⇒ If investors don’t pay enough attention to climate risk, exposed
firms are overvalued and will have low returns in the future

• Hong et al. (2019) find that food stocks in countries ranked high on
drought risk have low earnings and low returns

• Glossner (2021) finds that stocks with an ESG scandal have more
such scandals and low returns going forward

• Potential reason for divestment/underweighting

⇒ Occasionally investors may also overreact to salient climate-

related events (extreme heat, natural disasters)

• Choi et al. (2020) find that retail investors sell high-emission stocks
when it is hot

• Alok et al. (2020) find that fund managers in natural disaster zones
temporarily underweigh affected stocks

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 Municipal bond and real estate markets
• Physical climate risks likely to matter most for assets that cannot
"escape" effects from climate change
• Municipal bonds
I In the U.S., municipalities issue their own bonds backed by local
taxes (and there is no federal bailout guarantee)
I Big market: $3.9 trillion USD of outstanding muni bonds in 2020

I Painter (2020) finds that munis from counties with larger expected
losses from sea-level rise have higher yields at issuance

• Real estate
I Bernstein et al. (2019) find that homes exposed to sea-level rise sell
for 7% less than otherwise comparable homes
I Baldauf et al. (2020) find that this effect is weaker in communities
in which skepticism in climate change is widespread

⇒ Physical climate risks priced in municipal bond and real

estate markets
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 Green bonds and related instruments
• Growing issuance of green bonds, social bonds, sustainability
bonds, and sustainability-linked bonds

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 Green bonds (1/3)
• Green bonds = bonds issued by corporations, organizations, or
countries with the explicit provision that the proceeds are used for
environmentally friendly projects
• Issued as use of proceeds bonds, meaning the issuer is liable with
its entire balance sheet (while the bond proceeds are earmarked for a
green project)
• Credibility of "green" label depends on information provided by the
issuer and on the quality of external verification and certification
I Green Bond Principles = "voluntary process guidelines that
recommend transparency and disclosure and promote integrity"
I Climate Bond Standard and Certification Scheme = independent
verification process comprising a pre-issue and a post-issue report by
"approved verifiers"

• Social (sustainability) bonds = bonds whose proceeds are

earmarked to finance a social (sustainability) project
(for example, based on social bond principles)
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 Green bonds (2/3)

Question: Suppose a company has two bonds outstanding—one regular

and one green bond. Which bond do you think will have the lower yield
to maturity (YTM)?

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 Green bonds (3/3)
⇒ We expect green bonds to have lower yields to maturity (YTM)
compared to otherwise similar non-green bonds!
• A green bond comes with the constraint that the money must be
used for a green project
• If the green bond would not be cheaper, the issuer would prefer
issuing a regular bond without constraint
• Green bond investors are willing to lend at a lower rate since they
derive satisfaction (i.e., "nonpecuniary benefit") from knowing that
their money will be used for a green project
• Baker et al. (2018) find that yields on green bonds are 6 basis
points lower than yields of otherwise similar non-green bonds
⇒ One reason why firms may issue green bonds even if they were
not cheaper is the signal value (for environmental commitment)
• Flammer (2021) finds that stock returns and environmental
performance increase post-issuance
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 Sustainability-linked bonds

• Sustainability-linked bonds = issuer can use the proceeds as it

wants (not use of proceeds), but certain bond features (usually the
coupon) are structurally linked to pre-defined sustainability KPIs

• Example: issuer commits to reducing CO2 emissions by a fixed

amount by a certain time; if condition not met, coupon
automatically increases by a pre-specified penalty

• Interesting when, at issuance, the best green (or social) projects are
not yet clear (perhaps because of technological uncertainty)

• Investors should check that targets are ambitious and can be

credibly verified (see sustainability-linked bond principle)

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 ESG (1/2)
• Environmental, Social, and Governance (ESG) investing looks at
corporations’ environmental and social impacts alongside profit
• ESG investing in the U.S. has reached $17.1 trillion in 2020,
representing 33% of AuM (see US SIF 2020 trend report)

⇒ Environmentally responsible investment part of this megatrend

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 ESG (2/2)
• Motives for ESG investing:

1. Financial outperformance ("doing well by doing good")

I Evidence for ESG outperformance is mixed

I E.g., Financial Times article from May 3, 2021:

2. Protection against climate/litigation risks

I E.g., divest from high-CO2 firms to reduce exposure to transition risk

3. Desire to have a positive impact on society

I Riedl and Smeets (2017) find that investors follow ESG strategies
because of social preferences and not because of return expectations

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 Do YOU care about corporate externalities?

Question: Suppose you can buy a stock today that offers to pay you a
dividend of e10 in one year (and after this the firm closes). On top of
the dividend paid out to you, the firm may also donate money to a green
development project and/or cause environmental damages from pollution.

How much are you willing to pay for the stock?

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 Do investors care about corporate externalities?
• Bonnefon et al. (2019) run a very similar online experiment on
Amazon’s MTurk platform
• They find that participants are willing to pay $0.7 more ($0.9 less)
for a stock giving $1 more ($1 less) to charity

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Two strategies for environmentally responsible investors

1. Divestment

I Most ESG investment funds exclude firms with low-ESG scores (from
data providers such as MSCI or Sustainalytics)

I Norwegian Oil Fund—the world’s biggest sovereign wealth fund with

$1 trillion in AuM—has divested from coal manufacturers and other
sin stocks

2. Engagement

I Surveying institutional investors, Krueger et al. (2020) find that 43%

of them talk to firm management about climate risks, and another
30% submit shareholder proposals on climate risk issues

I Billionaire Chris Hohn, founder of the TCI hedge fund, launched the
Say on Climate campaign, rallying shareholders to force companies
to disclose their CO2 emissions

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 Divestment (1/4)

• In theory, divestment comes at the cost of lower diversification

benefits and a lower Sharpe ratio (SR)

I Diversification = "do not put all the eggs in one basket"

I Sharpe ratio of portfolio P defined as

E (rP ) − rF
SRP =
σP

I Portfolios that maximize the Sharpe ratio are efficient; i.e., they offer
the highest possible return for a given level of risk

⇒ Divestments reduce diversification benefits (σP ↑), thereby

decreasing the Sharpe ratio (SRP ↓)

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 Reminder: Portfolio theory
• N assets; asset i has expected return of E (ri ), standard deviation of
σi , and correlation of return with asset j 6= i of ρij
• Let wi be the portfolio weight of (=fraction of wealth in) asset i
NB: portfolio weights sum to one; short-sale positions have wi < 0

• E (rP ) and σP2 given by:

N
E (rP ) = ∑ wi × E (ri )
i =1
N N
σP2 = ∑ ∑ wi × wj × σi σj ρij
i =1 j =1
N N N
= ∑ wi2 × σi2 + 2 × ∑ ∑ wi × wj × σi σj ρij .
i =1 i =1 j =i +1

NB: for a portfolio of two stocks we have σP2 = w12 σ12 + w22 σ22 + 2w1 w2 σ1 σ2 ρ12

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 Quiz: Portfolio theory

Suppose there are four stocks—A, B, C and D—with equal expected

returns of 10%, equal standard deviation of returns of 40%, and zero
correlation between each other. The risk-free is 5%.

Portfolio P is formed by investing with equal weights in all four stocks.

1. What is σP ?

2. What is SRP ?

The Sharpe ratio of the (efficient) market portfolio M is SRM = 1.

3. What is the Sharpe ratio of a portfolio that consists of 50% invested

in M and 50% invested in the risk-free asset?

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 Divestment (2/4)
• Capital Allocation Line (CAL) with and without divestment
• Sharpe ratio of efficient portfolios = slope of the CAL
‫ܧ‬ሺ‫ݎ‬ሻ
CAL with brown and green stocks

T T’

CAL with green stocks only

‫ݎ‬ி

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 Divestment (3/4)
• How big are diversification/SR losses from divestment?
• Example: 1, 000 identical stocks with constant correlation

Rho = 10%
.6
.5
Sharpe ratio

Rho = 20%
.4 .3
.2

0 .2 .4 .6 .8 1
Fraction of excluded stocks

⇒ For large portfolios, loss in SR from divestments is negligible!

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 Divestment (4/4)
• If SR loss is small, what are the costs/benefits of stock exclusions?

• One benefit of divestment could be a reduced exposure to climate

risks (in particular, when these risks are not yet fully priced)
• One intended effect of divestment is to raise the cost of capital of
excluded ("brown") firms
I Effectiveness unclear, especially if there are many other unscrupulous
("brown") funds ready to buy up the stakes sold by green funds
(Broccardo et al., 2020; Berk and van Binsbergen, 2025)
I To the extent that divestment does raise brown firms’ cost of capital,
green funds underperform brown funds (Hong and Kacperczyk, 2009)

⇒ Divestments either have little impact or they tend to cause

underperformance; no "doing well by doing good"
⇒ May be detrimental to impact if divested firms come to be held
by brown investors and thus become difficult to engage
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 Engagement (1/2)

• Investors increasingly demand from companies to disclose and

improve environmental performance

I Climate Action 100+ is an investor-lead initiative to "ensure the

world’s largest corporate greenhouse gas emitters take necessary
action on climate change"

I Pressure from investors and regulators to implement guidelines from

Task Force on Climate-related Financial Disclosures (TCFD)

• Activist hedge funds seem to start targeting environmental

underperformance

I Akey and Appel (2019) and Chu and Zhao (2019) find that target
firms reduce toxic chemical emissions

I But could be a by-product of activists closing inefficient plants

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 Engagement (2/2)
• Dimson et al. (2015) find that successfull ESG engagements create
value for shareholders
I Returns for successfull (unsuccessfull) ES and G campaigns

⇒ Engagement more impactful than divestment and may

sometimes even "do well by doing good"
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 Most mutual funds use both exit and voice
• In a recent paper, my coauthors and I study how mutual funds
respond to ESG scandals in their: portfolios

⇒ Funds prioritize managing ESG risks in their portfolios over

impact (as exit undermines voice)
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 Carbon tax vs. climate finance

• In practice, regulation (carbon tax) and climate finance co-exist

I Carbon tax = direct (Pigouvian) tax on emissions

I Climate finance = increase cost of capital (CoC) of brown firms

• Pedersen (2024) develops a model to study their interaction

• Key results:

I When carbon tax = social cost of emission, climate finance is harmful

I When carbon tax < social cost of emission, climate finance can help

- but necessary increase in the CoC for brown firms implausibly large

- but effectiveness suffers from stranded assets

⇒ Climate finance is only an imperfect substitute for regulation

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 Conclusion

• Climate risks (transition and physical) are priced in financial markets

• "Sustainable finance" can help transition to the net-zero economy
I Green bonds help fund green investment projects

I Investors engage with companies to demand climate-related

disclosures and action plans—and divest from unresponsive
companies

⇒ Yet, sustainable finance is no alternative to efficient regulation

(e.g., carbon tax or cap-and-trade)

• Interested in more Finance?

I Practice oriented: Master in International Finance

I Research oriented: Quantitative Economics and Finance

Specialization, PhD in Finance

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 Appendix: Sustainability data

• Carbon emissions
Carbon Disclosure Project, Trucost, MSCI, Sustainalytics, Thomson
Reuters, Bloomberg, ISS

• ESG rankings
MSCI, Sustainalytics, Bloomberg, RepRisk, Arabesque

• Corporate disclosures
Task Force on Climate-related Financial Disclosures (TCFD), Say on
Climate

• Resources for consumers

The Good Shopping Guide, Ethical Consumer, Good On You,
Carbon Footprint

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