Mastering climate change has been recognised as a major challenge for the current decade. Besides the physical risks of climate change, the accompanying economic risks are substantial. Carbon Finance: A Risk Management View provides an in-depth analysis of how climate change will affect all aspects of financial markets and how mathematical and statistical methods can be used to analyse, model and manage the ensuing financial risks. There is a focus on the transition risk (termed carbon risk), but also a discussion of the impact of physical risks (as these risks are closely entangled) on the way to low carbon economies. This is a valuable overview for readers seeking an analysis of carbon risks from the perspective of financial risk management, utilising quantitative risk management tools.
Author(s): Martin Hellmich, Rudiger Kiesel
Publisher: World Scientific Publishing
Year: 2021
Language: English
Pages: 337
City: London
Contents
Prometheus Bound
Preface
About the Authors
Part I: Carbon Finance — Fundamentals
1. Climate Change
1.1 Climate Change Is Happening
1.1.1 Physical Evidence
1.1.2 Risk Perception
1.1.3 Scientific Evidence
1.2 Global Risk Management
1.2.1 International Climate Negotiations: Conference of the Parties (COP)
1.2.2 The Paris Agreement
1.2.3 The Role of Finance
1.3 Analysis
1.3.1 Uncertainty
1.3.2 Probabilities of Temperature Increases
1.3.3 Reference Scenarios
1.3.4 Resume
2. Climate Economics
2.1 Climate Change Policy
2.1.1 Economic Tools
2.2 Putting a Price on Carbon
2.2.1 Tax vs. Emission Trading
2.2.2 Multiple Policy Instruments
2.3 Emission Trading Schemes
2.3.1 Design of an ETS
2.3.2 Current Emission Trading Schemes
2.3.3 The EU ETS as an Example of Trading Schemes
2.3.4 EUA Prices
2.4 Carbon Credits
3. Climate Risks
3.1 Carbon Risks
3.2 CarbonMetrics
3.3 Sustainable Finance
3.4 Stranded Assets and Carbon Bubble
3.5 Tail Risk
4. Theory of Carbon Risk
4.1 What Should the Price for Carbon Be?
4.1.1 Utility Framework
4.1.2 Risk Aversion and Intertemporal Substitution
4.1.3 Ambiguity and Uncertainty
4.2 Asset Pricing Approaches
4.2.1 Discrete-Time Models
4.2.2 Continuous-Time Models
4.2.2.1 Carbon Dioxide Model
4.2.2.2 Climate Model
4.2.2.3 Economic Model
4.3 What Do the Markets Think?
4.3.1 Green Impact Investing
4.3.2 Green vs. Brown Stocks
Part II: Carbon Finance — Data
5. Carbon Finance and Artificial Intelligence
5.1 A Brief Introduction to Machine Learning
5.1.1 Linear and Generalised Linear Models
5.1.2 A Classification of ML Methods
5.1.2.1 Supervised Learning
5.1.2.2 Unsupervised Learning
5.1.3 ML-Based Estimation of Carbon Intensities
5.2 Applying AI to Carbon Risk
5.2.1 Motivation
5.2.2 Building an AI model
5.2.2.1 Data Handling
5.2.2.2 Selection Strategy for ML Methods
5.2.2.3 Model Size and Complexity
5.2.2.4 Dependence on Training Data
5.2.2.5 Generalisation vs. Overfitting
5.2.2.6 Explainable Machine Learning (XAI)
5.2.2.7 Societal Implications
5.2.3 Data Protection/Differential Privacy
5.3 Federated Learning
5.3.1 Horizontal Federated Learning
5.3.2 Vertical Federated Learning
5.3.3 Rationale for the Use of Federated Learning
5.3.3.1 Attack Scenarios
6. Disclosure and Data Requirement
6.1 Disclosure
6.1.1 The Need for Disclosure Standards
6.1.2 Current State of Disclosure
6.1.3 Data Provider
6.2 Data Quality
6.3 Federated Disclosure and Sustainability Ratings
6.3.1 Methodology of Ratings
6.3.2 Risks
6.3.3 Security Techniques
6.3.4 Application and Outlook
7. Markets for Trading Carbon Risk
7.1 Carbon Rights and Offsets
7.1.1 Definitions
7.1.2 Current Status of the Voluntary Carbon Market
7.1.3 Risks Associated with Tradable Carbon Rights
7.1.4 Role of the Trading Infrastructure
7.1.5 Market Integrity, Transparency, and Fairness
7.1.6 Challenges in the Carbon Market
7.2 Development of Carbon Credit Markets
7.3 Blockchains — A Short Introduction
7.3.1 General Principles
7.3.2 Blockchains as Trading Infrastructure
7.4 A Blockchain-Based Trading Infrastructure for Carbon Credits
7.4.1 Setting Up Trading Infrastructure
7.4.2 Blockchain Use Cases
7.4.2.1 Reforesting and a Long-Term Contract
7.4.2.2 Building an Additional Wind Park
7.4.2.3 Protection Against Double Counting
7.4.2.4 Fake Reforesting
7.4.2.5 Determining the Carbon Footprint of a Country
Part III: Carbon Finance — Markets
8. Emission Certificates on Financial and Energy Markets
8.1 Dynamics of EU ETS Certificates
8.2 Stochastic Models for Emission Certificates
8.2.1 Equilibrium Models
8.2.2 Reduced-Form Models
8.3 Effects on Financial and Energy Markets
8.3.1 EUA Certificates and Financial Markets
8.3.1.1 Stock Prices and EUAs
8.3.1.2 Credit Default Swap Spreads and EUAs
8.3.2 EUA Certificates on Electricity Markets
8.3.3 Green Power Purchase Agreements
9. Carbon Risk and Empirical Asset Pricing
9.1 Constructing Factor Models
9.1.1 The Capital Asset Pricing Model and Multi-Factor Models
9.1.2 Panel Regression
9.2 Stock Returns and Carbon Risk
9.2.1 Carbon Risk as an Additional Factor in Multi-Factor Models
9.2.2 Is There a Carbon Risk Premium in Equity Markets?
9.3 Carbon Risk, Cost of Equity Capital, and Cost of Debt
9.4 Carbon Risk and Machine Learning
10. Carbon Risk and Default Risk
10.1 Modelling Default Risk
10.1.1 Merton’s Structural Model
10.1.2 Credit Default Swaps
10.1.3 The Importance of CDS Spreads for (Bank) Risk Management
10.1.4 Determinants of CDS Spreads
10.2 CDS Spreads and Carbon Risk
10.2.1 ESG Factors
10.2.2 ESG-Based Carbon Indicator
10.3 Heterogeneity of Carbon Risk Effect
10.3.1 Quantile (Panel-) Regression
10.3.2 Quantile Analysis of CDS Spreads
10.4 Carbon Risk and Bonds
10.4.1 Bond Prices and Carbon Risk
10.4.2 Further Bond Market Studies
11. Green Bonds
11.1 Green Bond Markets
11.2 Green Bond Standards
11.3 Green Bond Premium
12. Carbon Risk and Financial Institutions
12.1 Standard Risk-Management Considerations
12.2 The Role of Central Banks
12.3 Stress Tests
12.3.1 Design of Stress Tests
12.3.2 Applications of Stress Tests
13. Carbon Risk and Investors
13.1 Carbon Risk and Investment Portfolios
13.1.1 The Current State of Play
13.1.2 Carbon Accounting for Equity Portfolios
13.2 Hedging Climate Risk
13.2.1 A News-Based Climate Risk Indicator
13.2.2 Portfolio Approaches
13.3 Sustainability Optimisation
13.3.1 Introduction
13.3.2 Sustainability Filters: Relevant Data and Example Applications
13.3.2.1 Available Data: A Selective Overview
13.3.2.2 Examples of Sustainability-Related Filters and Results of Their Application
13.3.3 Portfolio Optimisation under Sustainability Constraints: A Mathematical Model
13.3.3.1 Definitions and Introductory Explanations
13.3.3.2 Asset Characteristics
13.3.3.3 Criterion Function and Side Constraints
13.3.3.4 Example Based on Simulated Data
Appendix A Basics from Probability Theory and Financial Mathematics
Appendix B Federated Learning Algorithm
B.1 The Algorithm
B.1.1 Federated Median in the Range [0,1]
B.1.2 Rank Statistics
B.1.3 Determining Participating Companies
B.1.4 Remarks on Optimisation
B.1.5 Local Rank Determination
B.2 Simulation
B.3 Concluding Remarks
Bibliography
Index
