Climate Change in the Theory of Finance

Abstract

Finance scholars are only recently attempting to bridge the gap in climate finance. This paper is essentially a literature review of the interaction of climate change and finance through the lens of financial theory. The demand for financing climate-resilient infrastructures such as clean energy projects, energy-efficient buildings, low-carbon transportation, water, waste management systems, and the supply side of financing these infrastructures was reviewed. Financial theories and frameworks such as the Modigliani and Miller theorem, capital asset pricing model (CAPM), option pricing, efficient market hypothesis, and agency theory were also amenable to analyzing climate change and finance problems. Specifically, the factors to consider when financing and funding climate-resilient infrastructure include the financing profile of the investment; potential for cost recovery from users; the extent to which quality is contractible; the level of uncertainty and complexity of the project and policy frameworks; financial market conditions; and optimal allocation of risks. As data collection improves, climate finance research can continue on a great ride with enormous benefits to the global community.

Keywords: Climate risk, Modigliani and Miller theorem, Asset pricing, Efficient capital markets, Option pricing.

DOI: 10.7176/JESD/11-18-04

Publication date:September 30^th 2020