Environmental finance touches almost every aspect of markets, business models, regulations, public finance, and infrastructure development. It includes energy, waste and water systems, electric grids, and urban infrastructure. Although some thoughtful regulatory tools and policies have been identified at local and state levels in the United States (Steven Cohen, William Eimicke, and Alison Miller’s “policy levers for sustainability”1 come to mind), no clear national energy policy exists and there are practically no green taxes. Instead, other market tools—including tax credits, loan guarantees, and subsidies (e.g., rebates)—are being used at the federal level to incentivize investment in a sustainable, renewable resource–based economy. In light of the threats to economic growth and the challenge of catalyzing sustainable investments in asset-intensive industries, realizing business model innovation for climate-friendly development appears ambitious regardless of the size of the economy.
In Environmental Finance and Investments, Marc Chesney, Jonathan Gheyssens, Anca Claudia Pana, and Luca Taschini analyze environmental commodity markets and how they can attract investments. The authors do not focus on climate economics or sustainability management but, rather, offer an assessment of carbon markets, drawing from many fields in finance, economics, and environmental science, including macroeconomics, commodity markets, project finance, and investments. Accordingly, the authors focus on the application of market-based instruments to incentivize the behavior and change needed to deliver environmental quality and mitigate environmental risk. More generally, they investigate the trade-offs among production, technological changes, and pollution in the context of environmental finance theory, which is a new research strand “that investigates the economic, financial, and managerial impacts of carbon pricing policies.”
In the introduction, the authors ask four key questions to show how political economy considerations often motivate carbon market design in practice:
- What conditions are necessary to ensure that carbon-pricing instruments curb emissions?
- What innovative investment strategies should international climate agreements and carbon-pricing mechanisms promote?
- How should emission-trading schemes address the trade-offs among production, technological changes, and pollution?
- What is the link between economic growth and the environment?
The recently approved Paris climate agreement and the associated need for business model innovation to bring about a low-carbon economy add further urgency to addressing these questions.
Part 1 of Environmental Finance and Investments covers the causes of climate change, its possible scenarios, expected impacts, and strategies for tackling those impacts. After a brief overview of the economics of market externalities and the use of taxation, subsidies, and regulatory mechanisms to price carbon emissions, the authors analyze cap and trade as the most efficient policy instrument to reduce emissions and improve local and regional environments.
Drawing substantially from Pigouvian taxation theory, Part 2 deals with (1) the challenge of attaching costs and damages to global warming, (2) overcoming a degree of uncertainty, and (3) regional and sectoral implications of the global nature of climate change–induced investor sentiment shock. For example, investing in mitigation (using a traditional cost–benefit analysis) makes sense when the local marginal costs of abatement equal the local marginal damages. However, a cost–benefit assessment of climate change damages is difficult to make because such damages are highly regional (or sectoral) and dynamic and are subject to reinforcing loops, paradigmatic shifts in economic policies, and intermittent market headwinds. In addition, climate change damages are generated locally but are a result of collective externalities.
To compare environmental damages across periods, a sensible discount rate is required. The discount rate greatly affects the economics of projects and the associated decision making, particularly in financing large-scale, capital-intensive, climate-compatible development. A high discount rate limits assessment of climate-induced damages to the current generation, whereas a low, or near-zero, discount rate implies equal climate change impacts across intervals.
Environmental Finance and Investments goes beyond the many issues and topics that are mainstays of technological investment (and disinvestment) decisions in cap-and-trade programs to discuss net present value, discounted cash flow, option pricing with the binomial model, and the pricing of European and US options using the Black–Scholes model. The book also provides an insightful review of the real-option approach as a viable decision-making tool for achieving compliance with environmental regulations. The models the authors use demonstrate how the real-option decision-making tool can be implemented in an environmental setting—for instance, by practitioners in regulated industries or in carbon-trading companies.
The final chapter, “Emission Price Dynamics,” concerns how these econometric models and concepts can be used to investigate energy prices and macroeconomic shocks. The authors discuss the key properties of carbon permit prices needed to determine the right modeling techniques that provide the best fit to the data. They consider deterministic and stochastic equilibrium permit price models and examine the relationship between those models and potential implications for carbon markets. In essence, analysis of market design considerations—including limitations in the banking and borrowing of emission allowances, equilibrium allowance prices, asymmetric information in the permit market, and strategic trading interactions—is needed for a better understanding of emission price dynamics.
The lesson of Environmental Finance and Investments is clear: Although carbon-pricing instruments have yet to become the “new normal” in the world’s economic landscape, they are definitely gaining prominence. Appropriately applying these instruments to the market can shift the burden of damages caused by polluting industries from those who suffer from it to the industries that are responsible for it. Instead of being prescriptive, the authors have simply pulled together the key fundamentals of carbon markets—including fairness, transparency, efficiency, and reliability—that have made these programs (particularly emission permits that are currently issued and traded on exchanges and over the counter) attractive to investors. The authors’ true gift for intertwining purely academic optimal market strategies, elucidated by means of simple game-theoretic methods, with examples of how they can be applied in carbon-pricing policy results in an important, thoughtful contribution. Environmental Finance and Investments can be read linearly, chapter by chapter, or it can be used by fund managers, regulatory investors, and green-finance experts as a reference to gain valuable insights into how to manage carbon markets.