While disasters related to climate change cause damage to properties, plant and equipment, another huge challenge for companies is how to adapt to the policy risks of increasingly stringent climate and environmental regulations.
This is the subject of a paper studying the impact of climate policy risk on firms’ financing decisions which contributes to a wider research agenda on sustainable finance at AMBS. The paper will soon appear in the Special Issue on Business and Climate Change in Management Science, a leading management journal.
Paper co-author Viet Dang, Professor of Finance at AMBS, says to mitigate climate change consequences, emission control regulations have been introduced around the world. However, such regulations pose considerable policy risks to the corporate sector due to substantial compliance costs. “Policy responses to climate change may have unintended consequences for the corporate sector, and it is important for both policymakers and businesses to understand and manage such regulatory risk.”
To explore the research question in depth, the authors studied the impact of the Nitrogen Oxides Budget Trading Programme (NBP) which was implemented in 11 US states with the aim of reducing ambient NOx emissions. In so doing they found that the regulation exerted an unexpectedly profound effect on companies' financial policies.
As co-author Dr. Ning Gao, Senior Lecturer in Finance at AMBS, explains: “The NBP was a climate regulation that sought to reduce regional NOx emissions and ozone transportation in the power utility sector by operating a cap-and-trade programme in these 11 states. We used sophisticated econometric methods to establish the causal effect of climate policy on the manufacturing sector and found that power and utility companies incurred significant compliance costs after the implementation of the NBP and passed these costs on to electricity consumers.
“As a consequence, the electricity price increased more than 9% in the compliant states. Because manufacturers are intensive electricity consumers, the NBP dealt a significant price shock to their cost structures. And due to the increased electricity prices manufacturing firms faced higher costs of debt, greater operational inflexibility, and higher financial distress risk.”
He says that in response these firms became more conservative on a wide range of financial and investment policies such as reducing their leverage, public debt exposure, payout to shareholders, and investments. “The NBP’s effect was more pronounced for companies that rely on electricity more intensively as an energy input, were closer to financial distress, and faced greater product market competition,” adds Dr. Gao.
The study shows how climate policy targeted at power and utility companies has effects on the wider corporate sector and especially manufacturing firms.
As Prof Dang comments: “Our study highlights the importance of understanding the implications of the transition risk associated with climate change policies for the corporate sector and we show that industrial companies factor this risk into their financial decisions. What is also interesting here is that the NBP actually came about because of a court ruling so companies were not expecting this policy and there was a strong element of surprise.
“The fact that we then saw a rise in energy prices shows how there is often a trade-off when it comes to introducing green energy measures. It shows how the transition to net-zero won’t come without significant cost for business, but the cost of not having stringent regulations is clearly worse.”
He adds that another implication is that, in the future, governments across the world may have to consider financial support, or innovative use of tax systems, to help businesses which are exposed to great fluctuations in energy prices. “At the end of the day there will have to be more stringent regulations across the world if we are to meet ambitious net-zero targets. We cannot just rely on companies and markets for these targets to be met, companies will have to respond to appropriate incentives from governments too.”
Planning for a greener economy
Dr. Gao adds that, in the inevitable transition to a greener economy, it is paramount for firms and organisations to form tangible plans to adapt to the changing natural and societal landscape.
“At AMBS we are committed to a spectrum of related projects aimed at leading the thoughts of climate transition for a wide range of stakeholders. Our study is among the first attempts to address this pertinent question and our findings add to an emerging strand of academic research and provide relevant policy implications.”
This study is specifically part of a wider research project on climate finance supported by the AMBS Strategic Research Investment Fund, in collaboration with Professor Jonatan Pinkse, Executive Director of the Manchester Institute of Innovation Research (MIOIR), and ongoing work with academics in the Centre for the Analysis of Investment Risk (CAIR).