Climate change poses one of the most pressing risks to our society and the global economy, with profound and wide-ranging consequences. Research has shown that rising temperatures and tropical cyclones reduce the global economic growth rate by approximately 0.25 and 1.3 percentage points per year (Burke, Hsiang, and Miguel, 2015; Carleton and Hsiang, 2016). Despite the massive economic impacts, there is a critical knowledge gap in understanding the underlying mechanisms that drive the long-term economic impact of climate change. Our recent study proposes a new economic mechanism to address this gap from a corporate innovation perspective.
Corporate innovation is pivotal in fostering productivity growth (Griliches, 2007; Kung and Schmid, 2015). Hence, the detrimental impact of climate change on economic growth extends beyond the physical damages if incentives and capabilities of corporate innovation are also affected. On the other hand, climate change can also act as a driving force for firms to pursue sustainable development and adapt to the changing climate through innovative strategies. Our research examines the relationship between climate vulnerability and corporate innovation activities and strategies on a global scale, as well as the channels through which climate risk impacts innovation.
Understanding Climate Vulnerability
Climate vulnerability, as defined by the Intergovernmental Panel on Climate Change (2014), refers to the propensity or predisposition to be adversely affected by climate change, which determines the potential severity of its impacts. Unlike other types of risks that may arise suddenly and can often be managed, such as supply chain disruption, climate vulnerability represents a longer-term risk that lies beyond the control of individual firms and poses significant threats to their survival and growth.
Climate change introduces new business risks that may impair firms’ performance and profitability. The increasing variability in climate and extreme weather events can disrupt supply chains, hinder business operations, diminish asset value and earnings, inflate operational costs, and jeopardize long-term business sustainability. For instance, semiconductor companies heavily reliant on ultra-pure water for manufacturing face revenue losses and production disruptions due to droughts and water scarcity. These challenges extend beyond the semiconductor industry and affect a wide range of businesses that rely on electronic devices. Similarly, rising temperatures increase energy costs for software and services companies operating energy-intensive data centers, leading to increased operational expenses.
Additionally, firms are exposed to transition risks stemming from societal responses to climate change. As technologies, markets, and regulations evolve in response to the need for climate mitigation and adaptation, businesses may encounter increased costs, challenges to the viability of their existing products and services, and devaluation of their investments. These transition risks can substantially impact firms’ financial performance, creating uncertainty regarding investment returns and amplifying the financial risks associated with long-term investments such as innovation and research and development (R&D).
Impacts on Innovation Capacity
A company’s ability to innovate is heavily influenced by infrastructure, the innovation environment, and the availability of resources such as funding and skilled labor. However, climate-related risks can have detrimental effects on these critical factors. Extreme weather events and climate change can hinder infrastructure development, reduce labor supply, diminish worker productivity, and introduce fluctuations in earnings, cash flows, and financing costs. As a result, climate-related shocks increase production and R&D costs. Without adequate support and resources, these challenges can undermine a firm’s innovation capacity and overall performance. The complex and uncertain nature of climate-related risks amplifies the difficulties businesses face in maintaining their innovative edge and adapting to the changing climate.
Climate Change Mitigation Technologies
In the face of high vulnerability to climate change, firms may proactively seek ways to adapt and mitigate these risks. One viable strategy is innovation itself. Climate vulnerability can act as a driving force for companies to embrace new technologies or applications that facilitate climate change mitigation and adaptation. Firms may strive to enhance resource productivity to reduce costs, transition to renewable energy sources, and develop sustainable technologies and green products or services. Moreover, delaying innovation can be costly for firms, potentially placing them at a significant disadvantage compared to their competitors. Therefore, despite the challenges posed by climate vulnerability, some firms prioritize innovation to navigate the complexities of climate change and protect their market positions.
In our research, we utilize the climate vulnerability index developed by the Notre Dame Global Adaptation Initiative (ND-GAIN) to assess the vulnerability of countries to climate change. Our study focuses on a comprehensive sample of 60,028 publicly listed firms from 88 countries spanning from 1995 to 2019. Our analysis reveals a compelling negative relationship between climate vulnerability and firms’ innovation activities, as evidenced by patent filings. These findings indicate that, on average, climate vulnerability significantly hinders firm innovation.
Furthermore, we delve into the mechanisms that drive this relationship. Possible mechanisms include reduced responsiveness of R&D to investment opportunities, lower private value of innovations, decreased incentives to innovate, managerial career concerns, and limited availability of financing. These channels collectively shed light on why businesses that face higher susceptibility to climate change tend to exhibit lower levels of innovation.
Additionally, our research uncovers that climate vulnerability prompts firms to engage in cross-border collaboration for innovation and establish international strategic partnerships. These collaborations often involve joint research initiatives, technology sharing, and in-licensing agreements. Furthermore, climate vulnerability incentivizes firms to adopt innovative technologies that can mitigate the impacts of climate change. It also reduces their inclination to pursue risky innovation strategies. These findings underscore the potential for climate vulnerability to drive innovation toward more sustainable and environmentally friendly practices.
Moreover, our study highlights the significant impact of climate risk exposure through global supply chains and customer locations on firms’ R&D investment and innovation. We find that the negative effect of climate vulnerability on innovation is pronounced among firms that pay greater attention to climate change, as measured by the Google search volume index. Furthermore, we extend our analysis to incorporate the influence of climate vulnerability in foreign subsidiaries on the innovation activities of multinational companies.
The implications of our findings are crucial for companies, policymakers, and regulators. We emphasize the importance for companies to build capacities that enable them to cope with and adapt to climate change, such as expertise in assessing climate risks and fostering collaboration. Governments are encouraged to reduce uncertainties associated with climate policies and regulations while providing more support (e.g., subsidies, long-term climate policy framework) to enhance firms’ incentives and capabilities for innovation and to promote global collaboration.
We shed light on the underlying mechanisms through which climate risk affects economic growth, not only through asset damage but also through corporate innovation, a key driver of economic prosperity. Our study underscores the significance of international collaboration in innovation as a critical tool for firms to address the challenges posed by climate change. Collaboration enables firms to leverage knowledge and resources, accelerating technological progress and the development of innovative solutions to mitigate the impacts of climate change. In light of these findings, it is essential for firms, policymakers, and regulators to take proactive measures in encouraging and facilitating global innovation collaboration and the adoption of sustainable practices.
Chen Lin is a Professor of Finance in the HKU Business School at the University of Hong Kong.
Tse-Chun Lin is a Professor of Finance in the HKU Business School at the University of Hong Kong.
Fengfei Li is a Senior Lecturer in Finance in the Deakin Business School at Deakin University.
This post was adapted from their paper, “A one-two punch to the economy: Climate vulnerability and corporate innovation strategies,” available on SSRN.