Sustainability and the financial system

Jun. 09, 2016

Harrison Hong, Professor of Finance and Economics at Princeton University and member of the Swedish House of Finance Scientific Advisory Board recently visited Stockholm. He is currently researching the effects of climate change on financial systems and we had the opportunity to talk to him on this topic.

Creating a more sustainable economy has come up on the top of the agenda in many places of the world, but implications for the financial system seems not to be as well understood. Why do you think that is?

– As the discussion has intensified, it has revealed a lot of blind spots in knowledge that needs to be researched. A recent example includes Mark Carney, the governor of the Bank of England. He warned that climate change will lead to financial crises and falling living standards unless the world’s leading countries do more to ensure that their companies come clean about their current and future carbon emissions. In general, many policymakers are concerned that the current economic model has broad global impacts on property, migration and political stability, as well as food and water security.

 

What can financial economics bring to the table in your opinion?

– I think we lack knowledge about how markets are pricing these risks. Do firms and investors realize climate risk and does it actually affect cash flows? If this is the case, do investors receive any compensation in carrying these risks that would compensate them for aforementioned bad or even disastrous outcomes. There is already a body of work in behavioral finance that would suggest that markets, under certain conditions, are less efficient in dealing with sharing risks. In my recent work, I actually find that draught does affect both cash-flows and predict returns for food companies. Therefore, markets may not be as efficient as we would want with respect to climate risk.

 

What does this mean for public policy?

– It is too early to say. We should have to collect more research evidence to reveal how financial markets deal with environmental risks. I´m both optimistic and excited about the prospects of this. There is a lot of research covering these topics now, and we should be able to bring a lot of results on the table in the next couple of years. Policy makers are often impatient, but I think there is a clear risk that we would take the wrong actions before we understand the underlying mechanisms in order to take informed necessary decisions.