The Impact of Climate Risk on Capital Stock and Optimal Financing Policies: A Theoretical Analysis

We develop an analytically tractable model of optimal financing policies for a risk averse decision maker who is exposed to climate risk causing a significant disruption to capital stock accumulation. We quantitatively identify certain thresholds of cash-capital ratio explicitly characterizing the paying out, external financing, and internal financing region. We find that paying out is never optimal while external financing can be optimal only if the decision maker’s cash-capital ratio becomes smaller than the external financing threshold. Interestingly, the important discontinuity and dramatic change in the decision maker’s optimal financing strategies occurs even when the possibility of climate risk is very slim. Overall, the decision maker finds it optimal to make safer and conservative optimal financing decisions for cash accumulation purposes in the event of climate risk.