Pricing of Climate Risks in the Capital Market of South Africa

Abstract

ABSTRACT: Climate risk represents an increasingly vital issue to countries, companies, and institutional investors, making it a reality but not a distant threat to humanity. Considering the effects of climate risks on firms' financial indices and financing options, the study investigates whether climate risk is priced by the capital markets of South Africa. The study used reported carbon emissions as a measure of climate risk of 81 listed companies in the Johannesburg Stock Exchange from 2011 to 2020 to examine whether climate risk is considered and priced by the South Africa capital market. Data was sourced from DataStream database- a global financial and macroeconomic time-series database providing data on equities, stock market indices, currencies, company fundamentals, fixed income securities, and key economic indicators. We used the two-step system Generalized Method of Moments estimation technique that copes with endogeneity concerns to corroborate the effects of climate risk on cost of capital and capital structure. We find that climate risk is priced in both cost of debt capital and cost of equity capital. Specifically, we find that an increase in a firm's exposure to climate risk increases the cost associated with issuing debt and equity capital. We also find that climate risk exposure decreases the debt-equity ratio. Additionally, the study showed that firm size, leverage ratio, capitalization, profitability, and turnover affect both cost of capital and capital structure of listed firms. The study concludes that climate risk is priced in cost of financing in the capital market of South Africa. The study recommends that firms should invest in installing eco-friendly machinery that aligns with changing market expectations in order to reduce their carbon emissions. The study therefore highlights the need for companies to proactively assess and manage climate risks, incorporate climate considerations into their strategic decision-making, and enhance their resilience to climate-related challenges.