CAFIN News, January 2024

In a recent article, Climate Risks and FDI, Prof. Galina Hale and Prof. Grace Gu, Co-Director and Steering Committee Member of CAFIN, respectively, study whether multinational firms react to climate risks (physical risk in terms of disasters and transition risk in terms of climate-change mitigation policies). They answer this question by examining the dynamics of Foreign Direct Investment (FDI) in the aggregate as well as at the firm level.  Their theoretical model predicts a reduction in FDI resulting from both risks, but an ambiguous interaction effect from emission productivity.  These theoretical predictions are largely consistent with their empirical findings, but in an extensive empirical analysis at six levels of aggregation they find only a minimal set of statistically significant effects.  However, their firm-level results suggest significant climate-risk effects and that growing attention to climate risks is likely to increase such effects on FDI going forward. 

Prof. Hale and Prof. Gu’s student, Teng Liu, recently completed a doctoral dissertation that included empirical analyses of the financial impact of climate change on bank lending, sovereign default risks, and household consumption behavior. For example, higher exposure to climate change, measured by temperature anomalies, reduces bank lending to farms, especially those that are smaller. UCSC environmental economics expert Prof. Jeremy West also served on Dr. Liu’s dissertation committee. Dr. Liu’s latest work is available here.

Prof. Alonso Villacorta, CAFIN Steering Committee member, recently co-authored “Firm-bank linkages and optimal policies after a rare disaster” in the Journal of Financial Economics. Rare disasters such as pandemics, environmental accidents, or geopolitical crises typically lead to business disruptions, creating significant and heterogenous cashflow shortages to firms. The paper characterizes the optimal policy design to support firms and prevent an immediate wave of corporate defaults after a rare disaster. The paper sheds light on suboptimality features in the observed policy responses to COVID-19 lockdowns. Such analyses will become increasingly relevant as climate change creates greater environmental uncertainties.

At a conference on the Indian economy at Cornell University in October 2023, Prof. Nirvikar Singh, Co-Director of CAFIN, presented his recent research on India’s “green transition,” the trajectory it can follow toward decarbonization, while continuing to grow the economy.  His talk emphasized the importance of renewables for electric power generation, electrification of transportation and industry, and reforms in agriculture, among other policies. Importantly, it provided an analysis of the financial costs of achieving the goal of decarbonization within the next few decades, and possible sources of finance, including domestic public sector resources such as taxes, private sector investment, and multilateral institutions. The analysis suggested that the incremental financial costs of green economic development are not out of reach, at 2-6% of GDP, but institutional innovations will be needed.