Climate change’s impact on the financial sector

In this article, Maite CARNICERO MARTINEZ (ESSEC Business School, Global Bachelor of Business Administration, 2021-2022, exchange student from the University of Salamanca) explains how climate change has affected the financial sector.

For the last two decades, the environmental awareness has progressively increased. People are worried about the consequences of the greenhouse effect and the gas emissions and environmental policies play an important role in governments’ agendas. At first, the focus was mainly on the economic activity’s repercussion on the environment and developing less polluting practices. But many actors have acknowledged the major repercussions of climate change on countries, firms, the financial sector and the global economy. Therefore, the management of the risks associated to climate change is crucial.

To illustrate this point, take for instance PG&E, California’s principal power supplier. After the California wildfires in 2018, the firm had to declare bankruptcy due to the damage that its infrastructure had suffered and the amount of obligations that it had to pay because of being responsible of the ignition. Nevertheless, the drought and the extremely high temperatures were crucial for the start, expansion and severity of the fires. Also, the insurance sector is one of the most exposed to the physical risks of the climate change.

There are some regions and sectors specially exposed to these risks, but in a globalized world, they will affect, more or less, all the countries and sectors and will challenge the financial sector. Many agreements have been signed to approach the situation, such as the Kyoto Protocol, the GRI Sustainability Reporting Standards in 1997 (the Global Reporting Initiative, GRI, is a ONG created by Coalition for Environmentally Responsible Economies, CERES; and the United Nations Environment Programme, UNEP), the 2030 Agenda in 2015 or the Green Pact in 2019.

Financial markets’ adaptation

Financial markets have to be adapted, like the 2008’s crisis proved, with measures to ensure the transparency of the environmental risks and the criteria applied. That is the consequence of the “greenwashing” (a marketing method that consists in the use of the ecological argument to communicate with the public to portray the business as an eco-responsible one, when that is in fact not true. Such practice is deceptive and can be likened to false advertising) a phenomenon that appeared due to the increasing demand of “green” financial products, which are financial initiatives, processes, products or services either designed to protect the environment or to manage how the environment impacts finance and the investment. The problem is the lack of clarity when we have to determine if a financial product is sustainable. Sustainable financial products are the ones that take into account social and environmental factors when investing. That can be evaluated using the ESG (Environmental, Social and Governance) criteria.

Despite the risks inherent to climate change, it is important to note that it also comes along with many opportunities related to finding solutions and alternatives to the problem, like the renewables energies, whose value has increased that much, that some are even talking about the formation of a “green bubble”. Also, there is an increasing demand of green bonds (fixed-income assets destined to the financing of projects that meet environmental criteria, sustainable activities or projects to minimize the climate change), green loans and deposits, and energetic efficiency plans.

Risk associated to climate change on the financial sector

But, how to measure the risk of climate change? First of all, we have to rank the exposures depending on criteria like the geographical area, business model, gas emissions or vulnerability towards physical changes. A good starting point is the TCFD (Task Force on Climate-Related Financial Disclosures) recommendations on what are the most exposed sectors. Then, using different scenarios, we have to measure the risk. Nevertheless, there is little evidence that the market has put a price on each type of climatic risk, and even when they are included on the risk measurement of the asset, they are not completely incorporated or they are subject to a very high uncertainty, resulting in a very high volatility.

To sum up, climate change and its raising awareness have completely altered the financial markets outlook. A new concern about the risk of the climate change has been brought up, but also new areas of investment that look very promising, even with the possibility of the development of a new bubble. Therefore, I think that those risks need to be taken into account and its importance is only starting to grow. In the future, we will see how climate change plays a great role in the financial markets.

How to compute the net present value of an investment in Excel

When the time comes that one must choose what project to embark on, there are several measures to compare the available options, such as the internal rate of return, the payback method and the net present value (also known as the “discounted cash flow” method or DCF). In this article, I will focus on the last one of these tools, which is the preferred by most financial analysts.

A project is a temporary, unique and progressive endeavor to produce a tangible or intangible result, for instance, a new product or a competitive advantage. It normally entails the execution of some tasks over a period of time, conditioned to limitations related to cost, quality or performance. During its implementation, an initial investment and a series of cash flows are to be generated at different times. Some examples of projects are: developing a new service, building a factory, and implementing a new process.

The Net Present Value (NPV) compares the present value of the future cash flows with the investment made at the beginning. The computation of the present value uses a the required rate of return. It takes into account the time value of money, translating future cash flows into today’s value, since the buying power of money today is greater that the buying power of the same amount in the future.

The NPV is the basis of the discounted cash flow model (DCF) which allows investors to compare the initial cash flow of expenditure against the present value of future cash flows. It could be used to evaluate whether an important investment is worthwhile, but also in mergers and acquisitions and to compare companies, like Warren Buffet does, because once we have calculated the different NPVs we will know which investment has the biggest gain.

To sum up, the NPV allows us to do evaluate investments from a financial point of view and select the best one.

Modelling of an investment

How can we calculate it?

The mathematical formula for the NPV is given by:

CF_t = cash flows of each period (from t=0 to t=T)
T = number of periods
r = discount rate or interested rate required of the investment. It is the rate of return that the investors expect on their investment

For a classical project, the first cash flow, CF₀, is negative and corresponds to the initial cost of the project and the following cash flows, CF_t for t=1 to t=T, are assumed to be positive. The NPV can be rewritten as

This formula clearly shows that the NPV compares the first cash flow on the one hand, and the present value of future cash flows on the other hand. As the initial cash flow is negative and the present value of future cash flows is positive, the sign of the NPV depends on relative weight of these two components.

Investment decision

The NPV can be used as a criterion for the investment decision.

If the NPV is positive, the investment should be made as it creates value.
If the NPV is zero, the investment should be made or not.
If the NPV is negative, the investment should not be made as it destroys value.

Advantages

The NPV of an investment is easy to calculate, specially nowadays with financial calculators and spreadsheets like Excel.
The NPV measures the effect of the investment on the firm’s value.
The NPV It takes into account the maturity of each cash flow.

Disadvantages

In order to compute the NPV, the discount rate has to be specified and it is a difficult issue.
The calculations are based on assumptions and estimations and the reality can differ from them.
Misestimations can be found in the initial investment, on the discount rate and on the projected returns of the project.
The NPV formula presumes that the cash flows are immediately reinvested at the same rate as the discount rate.
It presumes that the negative cash flows are financed with resources whose cost is also the discount rate.

How to compute the NPV on Excel?

Example

Excel is an extended tool in the financial world, also to calculate the NPV. Let’s take an example to illustrate how we can use it: we are offered a project in which we have to invest 42,000 euros and we will receive 8,400 euros the first year, 9,000 the second, 10,300 the third, 11,700 the fourth and 13,000 the last year.

Assuming that the discount rate is 6% per year, what will be the NPV?

Hand-made computation

We can do a hand-made computation of the NPV:

We find a NPV of €1,564.43. As the NPV of the investment is positive, we will take the project.

Computation with Excel

We can also use Excel to compute the NPV:

Useful resources

longin.fr website Cours Gestion financière (in French).

Mazars Excel IRR Function And Other Ways To Calculate IRR In Excel

Economipedia NPV definition (in Spanish)

HBR NPV use and calculation

HBR NPV limitations

MyManagementGuide Project definition

About the author

The article was written in December 2021 by Maite CARNICERO MARTINEZ (ESSEC Business School, Global Bachelor of Business Administration, 2021-2022, exchange student from the University of Salamanca).

Climate change’s impact on the financial sector

Climate change’s impact on the financial sector

Financial markets’ adaptation

Some important sustainable financial products:

Assets:

Investment funds:

Liabilities:

Risk associated to climate change on the financial sector

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