Finance and the environment

eco

Among the 120 “players in the French financial centre” (banks, financial analysts, insurance companies), a study by Ademe (Agence de l’environnement et de la maîtrise de l’énergie) shows that a large majority (88%) consider that climate issues must be taken into account in long-term management.

A rather encouraging result, given that the environment was a minor concern among asset managers until about ten years ago. However, only 24% of them specifically integrate climate change risks and opportunities into the valuation of their portfolios1. The study of this relationship between finance and the environment is the subject of this article.

finance

The example of the electricity market sheds light on the reasons that can encourage companies to focus on risk management, particularly environmental risk management. 2 To achieve this, they have traditionally used two tools: either vertical integration or forward markets.

However, while these two risk management approaches have given rise to an abundant academic literature, they have, paradoxically, always been the subject of separate studies: either these studies have focused on short-term risk management (the company using the financial market for this purpose3), or they have chosen vertical integration as a response to their long-term risk management needs.

The researchers first demonstrated that vertical integration and futures markets are two alternative mechanisms, insofar as they both allow risk diversification. More particularly for downstream companies, i.e. suppliers, this diversification allows them to open more customer accounts and increase their activity: the offer widens and correlatively the retail price decreases.

Competition is increasing in the marketing market, to the detriment of the profitability of the marketing industries but to the benefit of the consumer.

But there are some questions regarding the integration of sustainable development criteria into financial management. First of all, financial performance remains the primary objective of asset management in any situation, so it will be a matter of ensuring good results.

Secondly, it is necessary to define and select the social and ecological criteria to be used in the analysis of companies. Third, consider how the analysis is integrated into the portfolio. Finally, it is necessary to examine the different ways in which investors can change corporate behaviour.

Since the Basel II agreements in 2004, financial institutions have been required to hold an amount of capital that depends on the risk level of their positions. It is therefore essential for both companies and regulators to be able to assess the risk of each financial position, even when it is an investment in another company (e. g. a subsidiary).

On the one hand, the regulator wants to penalize the risk taken by imposing a sum to be immobilized, on the other hand, managers seek to minimize this sum, and not necessarily the risk. But which properties should verify an optimal risk measure so that environmental criteria can be taken into account as much as possible?

Value at Risk (VaR) is the most widely used tool in financial markets to assess risk. The 99% Tier VaR required by the Basel II agreements is defined as the smallest amount of equity that can cover losses in 99% of cases. It therefore does not take into account losses in the remaining 1% of cases.

In addition, for regulators, using VaR to assess risk is not entirely satisfactory because any risk can be broken down into small parts that are undetectable for VaR. Indeed, if this risk measure is used to determine the regulatory amount that a company must hold, creating subsidiaries that separately cover some of its risks allows a group to significantly reduce (and even cancel in some cases) the amount to be provisioned without reducing the risk on its positions.

To avoid these regulatory trade-offs, the researchers recommend using a subadditive risk measure, i.e., diversifying the sources of risk within the same company also reduces overall risk. This example of VaR therefore shows us the difficulty of integrating environmental elements such as climate change into corporate risk management.

Managers of “sustainable” funds face an apparently intractable dilemma: how to comply with industry standards and requirements, i.e., stay “in line” while highlighting the very specific characteristics of the funds.

environmental finance

It therefore appears that environmental issues can have a significant impact on the decisions taken by entrepreneurs with regard to their risk management. In addition, through these decisions, the other players in the financial centre will have additional decision-making factors. This explains the increasingly important impact of the environment on politics, the economy and finance and thus an increasingly strong relationship between them.

Morad VAHDATI

1 We are talking here about generalist management, not to be confused with SRI (Socially Responsible Investment) management and management specialising in certain environmental themes.

2 In the article “Hedging and Vertical Integration in Electricity Markets”, Gilles Chemla distinguishes two categories of risks: operational and financial.

3 As a reminder, liquid electricity futures markets rarely exceed 3 to 6 months.

Morad VAHDATI


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