+ Add to my selection

Decarbonization of Financial Markets: A Mean-Field Game Approach

In this paper, Peter Tankov, Scientific Director of the Green and Sustainable Research (GSF) Programme of Institut Louis Bachelier (ILB), and Pierre Lavigne, postdoctoral researcher at ILB, developed a model for the decarbonization of a large financial market, arising from an equilibrium dynamics involving companies and investors, and built using the analytical framework of mean-field games.

Decarbonization of industry is an essential ingredient for a successful environmental transition, and the financial sector has a key role to play in meeting the financing needs of green companies and directing the funds away from brown, carbon intensive projects. The amount of assets invested in climate-aware funds increased more than two-fold in each year between 2018 and 2021, reaching USD 408 billion at the end of 2021 (Morningstar Manager Research, 2022), and several authors aimed to quantify the impact of these additional funding flows on the emission reductions in the real economy. Such impact can be achieved only if green-minded investors target a sufficiently large proportion of companies, and the environmental performance of each company depends on factors which are not directly controlled by investors, such as the general economic situation, financial health of the company, and future climate policies. The decarbonization of a financial market is therefore the result of interaction of a large number of companies, operating in an uncertain environment, and should be modeled as a dynamic stochastic game with a large number of players.

In their paper, Pierre Lavigne and Peter Tankov construct a model of a financial market where a large number of firms determine their dynamic emission strategies under climate transition risk in the presence of both green-minded and neutral investors. The firms aim to achieve a trade-off between financial and environmental performance, while interacting through the stochastic discount factor, determined in equilibrium by the investors’ allocations. The authors formalize the problem in the setting of mean-field games and prove the existence and uniqueness of a Nash equilibrium for firms. They then present a convergent numerical algorithm for computing this equilibrium and illustrate the impact of climate transition risk and the presence of green-minded investors on the market decarbonization dynamics and share prices. Their research shows that uncertainty about future climate risks and policies leads to higher overall emissions and higher spreads between share prices of green and brown companies. This effect is partially reversed in the presence of environmentally concerned investors, whose impact on the cost of capital spurs companies to reduce emissions. However, if future climate policies are uncertain, even a large fraction of green-minded investors is unable to bring down the emission curve:  clear and predictable climate policies are an essential ingredient to allow green investors to decarbonize the economy.

The research of Pierre Lavigne was supported by ADEME (Agency for Ecological Transition).

Access the paper here.

Enjoy the reading!