The Systemic Risk of Climate Change

Climate change is one of the biggest problems that faces our modern world and the most far reaching. Climate finance, which refers to the investments that align the world with a transition to a state of reduced emissions of greenhouse gases and to mitigate against the risk of climate change, is a relatively new frontier for academics. We know from literature that the effect of climate change, combined with the goals to keep climate change to the limits set out by the Paris Agreement, have impacts at firm level and upon the financial markets. This poses great risk for the future if we do not start to act immediately. For this reason, there is need for deeper understanding of how these climate effects impact on the world of finance and the level of systemic risk they may cause. Systemic risk is the risk of financial collapse across financial systems, or the market, as opposed to the financial risk of an individual firm and was a major contributor to the economic collapse in the 2008 financial crisis. In my review of the published literature, I have identified gaps that I wish to fill through my research. I will contribute to the current literature (Hong et al. (2020)) in answering the main thesis question: 'What is the effect of climate change on the systemic risk of firms?' In order to qualify proof of my research question, I propose to undertake three different sub-research questions and investigations from the gaps I have found in the literature. These are: 1. How do climate change effects such as variation in temperature and precipitation affect the systemic risk of firms? 2. How do climate change disasters such as droughts and wildfires affect the systemic risk of firms? 3. Do rising sea levels and flooding cause increased stock market volatility? To answer the first two questions, I will undertake a risk modelling methodology known as CoVaR. An attractive modelling technique, as we can pinpoint which firms are affected by the climate shocks and the interconnectivity between firms of these risks. CoVaR allows modelling of the Value at Risk dependency of the climate change effects and then a regression analysis follows, showing if climate change effects indeed do have
effect on the modelled systemic risk. The methodology to answer the third research question follows a thorough framework presented by Murfin and Spiegel (2020). Using data to calculate cross sectional differences between sea level rise (SLR) and coastal distance, the time to inundation will then be modelled. An analysis will be performed, modelling the price of the firm may be impacted by the previously modelled time to inundation. A regression analysis is used as a test setting to investigate if price volatility is indeed caused by the firm's location and SLR risk. The results of my research will add to a greater understanding of the financial risk caused by climate change. I will provide a framework to build a database indicating which climate risks affect which firms and the interconnectivity of these risks and firms. This database would help in using the financial markets as a driving force for positive action in the mitigation of the effects of climate change and for policy makers to have a greater understanding of climate risk in the financial system.