Relationship Between Climate Risk and Physical and Organizational Capital.

VerfasserKanagaretnam, Kiridaran

"Once again, climate change has gained a prominent position in the risk ranking... That means that climate-related risks make up the majority of the top-rated risks..." --World Economic Forum's (WEF) 2018 Global Risk Report 1 Introduction

Climate change is recognized as one of the most significant risks faced by firms around the world. It is likely that climate change will worsen and continue to pose a material threat to global business activities in the foreseeable future until appropriate actions are taken to cope with increases in global greenhouse gas emissions. Climate change is inextricably related to corporate strategy because its macro impact filters down to the firm level. As suggested by Romilly (2007), international business activities should adapt to new challenges stemming from climate change. Given that climate change is germane to both domestic and multinational enterprises (MNEs), there is a surprising dearth of research addressing the impact of climate change on business investments. Recently an emerging strand of international business (IB) literature has started to focus on the impact of climate risk on business activities around the globe (e.g., Huang et al., 2018). Thus, the primary focus of the current research is to have a better understanding of the relationship between climate risk (1) and corporate investment in organizational capital (OC, hereafter) and physical capital (PC, hereafter). Following prior literature (e.g., Li et al., 2018), we define OC as a firm's stock of knowledge, capabilities, business processes, and systems that facilitate the match between labor and physical input to enhance corporate production efficiency, (2) while PC is defined as tangible, man-made goods and physical assets used in the production process and different from OC (Eisfeldt & Papanikolaou, 2013). Understanding whether and the extent to which climate risk relates to firm-level investment in PC and OC is critical not only because of the potential damage to investments arising from the frequent occurrence of extreme weather patterns but also because of the important role played by corporate investments in sustaining firm value.

Climate risk stemming from global warming engenders a significant level of uncertainty. Heal and Millner (2014) suggest that there are two types of climate change uncertainty: scientific uncertainty and socio-economic uncertainty. (3) Scientific uncertainty arises from the lack of knowledge to understand the inherently complex nature of climate change, whereas socio-economic uncertainty stems from the lack of understanding of the economic or social impact of climate change. Scientific uncertainty and socio-economic uncertainty correspond to physical risk and climate transition risk, respectively, related to climate.

We posit that climate change uncertainty should be distinguished from policy or political uncertainty for at least two reasons. First, scientific uncertainty inherent in physical risk is highly unpredictable and largely out of the control of managers. The existing literature documents a high level of uncertainty associated with climate risk in terms of observed changes in the climate system, understanding of the climate system, and projections of global and regional climate change (IPCC, 2013). Second, socio-economic uncertainty inherent in climate transition risk encompasses elements of policy or political uncertainty. For example, it is possible that increasing transition risk will increase policy uncertainty on carbon dioxide emission standards and carbon tax. Given the underlying disparity between climate change uncertainty and policy or political uncertainty, the impact of climate change uncertainty on corporate investment could be different from that of policy or political uncertainty.

The impact of uncertainty on capital investment has been extensively investigated in the economics and IB literatures (e.g., Bernanke, 1983; Bloom, 2009; Campa, 1994; Lee & Makhija, 2009; Nguyen et al., 2018). More recently, using the Economic Policy Uncertainty (EPU) index developed by Baker et al. (2016), several studies document a negative relationship between EPU and capital investment (e.g., Baker et al., 2016; Gulen & Ion, 2016). In addition, a related strand of literature explores the impact of political uncertainty on capital investment and reaches similar conclusions (e.g., Jens, 2017; Julio & Yook, 2012). Overall, there is mixed evidence regarding the relationship between policy or political uncertainty and corporate investment.

Building on prior literature, we posit that climate risk could relate to corporate investment in different ways due to the underlying heterogeneity between climate change uncertainty and policy or political uncertainty, even though the detailed mechanism through which climate risk relates to corporate investment is still unknown. Unlike existing research that typically focuses on PC, we complement this literature by examining the impact of climate risk on both PC and OC. This is because the importance of OC has been highlighted in the recent literature (e.g., Eisfeldt & Papanikolaou, 2013, 2014; Li et al., 2018) and also because of the inherent heterogeneity between PC and OC.

OC has been shown to influence both country-level and firm-level strategic advantages. At the country level, Atkeson and Kehoe (2005) demonstrate that OC represents more than 40% of the cash flow generated by all intangible assets in the U.S. national income and product accounts. At the firm level, studies show that OC facilitates superior operating, investment, and innovation performance, which in turn enhance future operating results, stock return, and deal performance (Lev et al., 2009; Li et al., 2018). Unlike PC, OC is not capitalized and does not appear as an asset on a firm's balance sheet. Instead, it is expensed immediately according to generally accepted accounting principles (GAAP), given that selling, general and administrative (SG&A) expenditure is a significant component of OC (Eisfeldt & Papanikolaou, 2013, 2014). In addition, OC could create agency problems. As suggested by Eisfeldt and Papanikolaou (2013), both shareholders and key talents have claims on the cash flow accruing from OC. Therefore, shareholders may demand a higher risk premium to invest in projects related to OC relative to those related to PC. In the context of climate risk, the higher risk premia required by shareholders may deter OC investment. Given the heterogeneity between PC and OC, their relationships with climate risk are likely to differ.

We examine the relationships between climate risk and PC and OC using 175,360 firm-year observations from 39 countries over the period 2006-2017. We measure climate risk using the 2008-2019 editions of Germanwatch Climate Risk Index. We measure PC using physical capital expenditure and OC based on SG&A expenditure using the perpetual inventory method. Our main findings show that climate risk is positively associated with PC and negatively associated with OC. We extend our analysis up to three future years, conduct an extensive array of robustness tests, and find that our main results continue to hold. These findings suggest that PC investment aimed at mitigating climate risk may influence the level of OC investment. Overall, given the sheer magnitude of SG&A expenditure as well as the critical role of OC in sustaining firms' future performance (Lev et al., 2009), the negative impact of climate risk on OC might outweigh its positive impact on firm-level PC expenditure, providing micro-level empirical support for prior studies such as Dell et al. (2012) and Letta and Tol (2019), which document a negative impact of climate change on economic growth.

We conduct several additional cross-sectional analyses. First, we investigate whether the relationship between climate risk and corporate investment in PC and in OC is sensitive to country-level climate risk awareness. Second, we investigate the moderating role of country-level climate risk resilience on the relationship between climate risk and corporate investment in PC and in OC. Third, we investigate the joint effect of climate risk awareness and country resilience on the relationship between climate risk and corporate investment in PC and in OC. Our findings demonstrate that the positive (negative) impact of climate risk on PC (OC) is more pronounced in countries with high (low) climate risk awareness, and in countries with high (low) climate risk resilience. More importantly, our findings show that the positive (negative) impact is magnified in countries with both high climate risk awareness and resilience (low climate risk awareness and resilience).

Our study contributes to the literature in several important ways. First, it contributes to the emerging strand of the IB literature that investigates the impact of climate change on firms' outcomes and behaviors in an international setting (e.g., Huang et al., 2018) by focusing on the differential impact of climate risk on PC and OC. In this regard, we extend the study of Huang et al. (2018) by focusing on the impact of climate change on corporate investment. To our knowledge, this is the first study to examine the impact of climate risk on firm-level investment. (4)

Second, our study adds to the literature on the impact of uncertainty on corporate investment. It differs from the existing literature, which largely focuses on policy or political uncertainty (e.g., Baker et al., 2016; Gulen & Ion, 2016; Julio & Yook, 2012; Lee & Makhija, 2009), by focusing on the implications of climate change uncertainty for international investment. Specifically, our results document that climate risk is one of the cross-country determinants of corporate investment. More importantly, prior literature indicates that uncertainty is generally negatively related to PC investment, whereas our evidence documents a positive association with climate risk.

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