Climate change poses risks to economies and can influence the attractiveness of countries for foreign direct investment (FDI). Countries vulnerable to climate-related disasters may experience disruptions in supply chains, and business operations. Countries with inadequate climate change adaptation and mitigation measures may face reputational risks and may be perceived as undesirable investment destinations. However, climate change can also throw up investment opportunities in renewable energy, clean technologies, and sustainable infrastructure.
Governments and businesses that prioritise climate action and implement policies supporting green investments are likely to attract foreign direct investment from companies seeking to capitalise on the transition to a low-carbon economy. Investors may be drawn to countries with favourable regulatory frameworks, incentives, and stable policy environments for clean energy and sustainable projects. At an online lecture organised by EGROW Foundation, economist Galina Hale discussed the need to study the complex relationship between climate-related risks and FDI flows. Edited excerpts:
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Impact of climate risks on FDI
Galina Hale, Professor of Economics at UC Santa Cruz
The physical risks associated with climate change are enormous, especially in the case of India. This necessitates increased private sector investment in climate adaptation solutions and mitigation efforts. The challenges involved in investing in adaptation solutions are significant because of insufficient action taken in the past three decades.
The minimal responses from firms, including multinational corporations, to both physical and transitional risks may have consequences if firms fail to respond promptly. These include sudden and significant business relocations away from countries with stringent greenhouse gas policies or high physical risks from extreme climate events.
Measuring the effects of climate risks is a challenging task. It is difficult to predict the future based solely on historical patterns. It is crucial to acknowledge the limitations of deriving empirical results solely from past data and the absence of a precise framework. This necessitates the use of partial equilibrium models that focus on multinational mergers and acquisitions to address some of these issues.
Extensive empirical research is needed to investigate the effects of climate risk on multinational mergers and acquisitions decisions at various levels of analysis, including country-level, bilateral country pairs, country industry level, and firm level. This necessitates the introduction of the concept of climate risk exposure or awareness as a measurement at the firm level to determine differential reactions between firms that consider climate risks and those that do not.
The existing research on this topic is limited, with some studies focusing on country level analysis or global supply chains, and few addressing foreign direct investment. This makes the author’s comprehensive investigation of different levels of aggregation unique.
Overall, employing a partial equilibrium model and conducting extensive empirical analysis to examine the effects of climate risks on multinational mergers and acquisitions is crucial, considering emission productivity and climate risk awareness at various levels of analysis. Incorporating these factors into empirical work can significantly influence the results, despite the challenges in obtaining empirical data on emission productivity,. This is addressed using the World Input-Output Database Environmental Accounts at the industry level.
The inclusion of emission productivity in studies is crucial to avoid misleading outcomes, yet the lack of emissions data for firms in most countries hinders research in this area. This highlights the importance of globally implementing the US Securities Exchange Commission’s proposal for climate risk disclosure based on the Task Force on Climate-related Financial Disclosures framework for policymaking and research.
There is a lack of consistent evidence to support the notion that physical or transition risks significantly influence investment location. However, the author’s study shows that firms became more responsive to climate risks after the implementation of the Paris Accord in 2016 and countries with higher emission productivity are less likely to experience foreign direct investment outflows following extreme weather events.
An examination of the relationship between physical and transition risks, emission productivity, and FDI in target countries emphasises the importance of including emission productivity in research, the necessity for improved data collection on firm emissions, and the potential influence of global climate risk disclosure policies on policymaking and research.
There is a need to reduce health risks in all scenarios, especially for multinational corporations (MNCs) and their affiliates in foreign countries. MNCs acquire foreign affiliates at a discounted price, calculating the inflow of FDI by multiplying the purchase price by the number of affiliates, and the internal determination of each affiliate’s price.
Both MNC affiliates and local firms produce different varieties, resulting in monopolistic competition. While the model considers transition risk as a constant parameter, it can be replaced with the expectation of policies, treating it as a random variable, without affecting the model’s predictability. The impact of physical climate risks on overhead costs for affiliates increases due to higher capital costs and potential equipment restoration after a disaster, leading to a logical decrease in the number of affiliates in the target country.
When climate policies such as carbon tax are enacted to raise emission unit costs, the number of affiliates declines due to increased production expenses. These policies also alleviate the impact of physical risk, aligning with the initial proposition. Additionally, advancements in greener practices and increased emission productivity can either amplify or dampen the number of affiliates in a country.
An examination of the connection between climate risks and foreign direct investment reveals that as climate risks increase, high-productivity firms become more vulnerable, leading to a decline in FDI. Physical risks such as natural disasters and transition risks associated with becoming a low-carbon economy can impact FDI, and the influence of these risks on FDI can be amplified or mitigated through appropriate policies.
On an average, emission productivity is higher in advanced economies compared with emerging economies, making the impact of climate risks on FDI more pronounced in advanced economies. Therefore, focusing on reducing emissions at the country and industry level is crucial to attract higher FDI inflows. However, FDI can have both positive and negative effects on emission productivity, highlighting the need to examine emissions at the firm level for a better understanding of these effects.
It is worth noting that higher emission productivity does not necessarily result in increased FDI, contrary to expectations. This is due to composition effects that arise when aggregating service and manufacturing industries at the country level. So, significant effects on the intensive margin are not consistently observed. However, when examining the extensive margin, a consistent finding is that FDI inflows decrease during climate events in advanced economies. Outflows of FDI can be observed from emerging economies during floods, and from advanced economies due to policy changes like carbon tax.
Certain results exhibit an ambiguous nature, as the effects of climatological and meteorological factors are opposite, consistent with existing literature. The reasons behind this phenomenon remain unclear. Overall, the impact of climate-related risks on FDI in advanced and emerging economies reveals a higher FDI outflows in response to meteorological and hydrological effects, especially from advanced economies. Other effects not explicitly mentioned either have no significant impact or show an equal number of positive and negative effects, rendering the overall impact non-robust.
The influence of climate-related risks on foreign direct investment flows varies based on the nature of the economy and the extent to which firms are exposed to climate risks. These results underscore the significance of considering these factors when studying the impacts of climate change on FDI. To further delve into these relationships, acquiring additional data and conducting thorough testing are imperative for more robust findings.