Environmental Value Adjustments for Asset Pricing

Abstract

In this thesis, we explore how environmental aspects can be incorporated into asset valuation in the financial sector to internalise climate change economically. We propose several Environmental Value Adjustment (EVA) models and demonstrate their application by financial institutions and authorities to mitigate climate-related risks. EVAs are expressed in terms of an Environmental Impact Factor (EIF), quantifying the climate impact of assets relative to their exposure. We show that EVA formulation in terms of EIF allows seamless integration into existing xVA models. We introduce a Climate Risk Value Adjustment (CRVA) based on climate risk-related adjustments to the CVA of assets, addressing uncertainties associated with physical climate risk over a long time horizon.

Additionally, we examine the current infrastructure of the Voluntary Carbon Market (VCM) and identify issues that prevent it from being deployed as a climate change mitigation mechanism. As the VCM matures, financial institutions can achieve net zero by offsetting financed emissions using voluntary carbon credits. We propose a Financed Emissions Value Adjustment (FEVA) model that incorporates these costs into asset valuation based on the Partnership for Carbon Accounting Financials (PCAF) standard. Finally, we define a stochastic control problem to identify cost-minimising carbon credit buying strategies, which we solve using a least squares Monte Carlo approach. We assess its effectiveness and limitations, particularly in conjunction with the proposed higher-dimensional VCM model.