Summary:
The national climate change adaptation strategy 2035 identifies mitigation and adaptation as the two complementary and indispensable strategies for addressing climate change. While research on mitigation, centered on carbon emission reduction, has become extensive and in-depth, the worsening climate risks, marked by increasingly frequent and severe climate disasters, have created an urgent and pressing need for research on adaptation, which focuses on building resilience to physical climate risks. Yet adaptation research remains scarce, both in its theoretical foundations and its empirical evidence. A crucial aspect of adaptation is narrowing the climate adaptation investment gap. Climate adaptation investment encompasses all activities that strengthen resilience to physical climate risks, aiming to reduce future economic and social losses from climate disasters. The climate adaptation investment gap specifically refers to the shortfall between the amount of investment required to achieve a targeted level of resilience against physical climate risks and the actual investment that can be mobilized in practice. In reality, a substantial gap persists, posing serious threats to sustainable development. This paper focuses on a key private sector setting in which firms undertake climate adaptation investments and banks provide the credit to finance them. Given that firms exhibit heterogeneous levels of exposure to climate disasters, their adaptation needs and corresponding investment approaches differ considerably. Consequently, when firms seek credit for adaptation investments, banks face severe information asymmetry if they cannot effectively observe and assess firms’ real adaptation needs and the specific investments required. This information asymmetry, often leading to moral hazard problems in the credit market, may be a critical driver of the observed adaptation investment gap. Building on this setting, we construct a theoretical model in which a firm simultaneously finances two types of investments through bank credit: productive investment and climate adaptation investment. In the model, depositors, banks, and the firm sign loan contracts for both investment types. Given the presence of information asymmetry in both types of investments, banks monitor both activities. We then examine how information asymmetry in adaptation investment shapes the investment gap and explore how financial regulatory policies can address this market failure, along with their theoretical underpinnings. The theoretical analysis yields three main findings. First, deeper information asymmetry in adaptation investment intensifies moral hazard, preventing the optimal level, which is relatively high, of adaptation investment from obtaining a loan contract, thereby creating the adaptation investment gap. Second, greater bank monitoring effort can boost firms’ adaptation investment by mitigating information asymmetry, yet the gap persists even under the optimal choice of monitoring effort. Third, when the current level of adaptation is low (high), a reduction (increase) in the credit risk weight for such loans under financial regulatory policy induces banks to increase monitoring effort, thereby narrowing the investment gap. Moreover, this policy effect strengthens (weakens) over time, suggesting a dynamic adjustment mechanism. These theoretical findings are empirically validated. This paper makes three contributions to the literature. First, it provides an analytical framework for studying credit financing issues, especially information asymmetry, when firms seek to build resilience to physical climate risks. Second, through the lens of information asymmetry, a foundational concept in corporate finance, the paper uncovers the mechanism generating the adaptation investment gap and reveals how bank monitoring influences the gap, thereby enriching our understanding of its determinants. Third, it elucidates the specific mechanism through which financial regulatory policy affects the adaptation investment gap, traces its dynamic evolution over time, and clarifies the policy's exit strategy. These insights provide a useful reference for central banks that seek to advance climate adaptation, with a focus on building resilience to physical climate risks.
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