The business world is increasingly aware of the risks and opportunities climate change presents. Companies are developing and commercializing new products and services that contribute to a low-carbon economy, or “climate solutions” (CS). In the recent HBS working paper, “The Financial Anatomy of Climate Solutions: A Large Language Model Approach to Company Classification and Analysis,” researchers Shirley Lu, Assistant Professor at Harvard Business School, and George Serafeim, Charles M. Williams Professor of Business Administration at Harvard Business School and Principal Investigator of D^3’s Climate and Sustainability Impact Lab, leveraged cutting-edge artificial intelligence (AI) technology to study the financial performance of firms involved in CS.
Using SEC regulatory filings (Item 1 of the 10-K filing, “Business Description”) from 2005-2022, the authors used large language models (LLMs) to measure companies’ focus on CS by mapping the language to 88 CS topics and categorized companies accordingly:
- Pure CS: Companies primarily dedicated to CS, such as Tesla and Beyond Meat
- Transition CS: Companies moving toward CS, such as General Motors (GM) and AES
- Non-Transition: Companies not shifting products and services
Key Insight: Climate Solutions Drive Revenue Growth
“We find that companies with higher climate solutions exhibit superior revenue growth, consistent with higher demand for these products and services.” [1]
Lu and Serafeim’s research revealed a positive correlation between a company’s focus on climate solutions and its revenue growth. The study shows that firms with higher CS have significantly higher revenue growth compared to their peers, indicating a strong demand for these offerings. They found that Transition CS firms experienced 1.7% higher revenue growth compared to Non-transition firms.
Key Insight: Higher Costs and Profitability Challenges for Pure Climate Solution Firms
“We expect and find a lower profitability ratio for Pure CS companies, driven by a lower profit margin (11.8% and statistically significant compared to Non-Transition firms) […] We find that the lower profit margin for Pure CS firms can be explained by a 6.2 cents (per dollar of revenue) higher cost of goods sold (COGS), 9.1 higher selling, general and administrative expenses (SG&A), and 3.3 higher research and development expenditures (R&D).” [2]
While climate solutions drive revenue growth, the study uncovered notable cost and profitability challenges, particularly for Pure CS firms, which tend to have lower profit margins compared to their Non-transition counterparts. The analysis revealed that companies focusing on CS face higher costs across various categories, including investments in materials, talent acquisition, and product innovation.
Key Insight: Varying Financial Performance Based on Climate Solution Focus
“We differentiate between [the Pure CS and Transition CS] types of companies as we expect them to exhibit distinct business fundamentals.” [3]
Using 88 CS topics, the researchers mapped each one to estimates of carbon abatement potential and cost. They found that not all solutions have the same impact on a company’s bottom line. Solutions with higher carbon abatement potential tend to drive revenue growth, while those with higher implementation costs lead to increased expenses. In terms of growth, the authors found that:
- Pure CS firms can use their more straightforward focus to grow faster than Transition CS firms; however, as they invest in production and brand-building, they show lower profitability margins.
- Transition CS firms might be able to grow faster by leaning on their existing brands, labor, manufacturing, and distribution channels.
Why This Matters
For business leaders and investors, understanding the financial anatomy of climate solutions is crucial in navigating the transition to a low-carbon economy. Lu and Serafeim’s research provides valuable insights into the growth opportunities and profitability challenges associated with developing and deploying climate solutions. However, the study also highlights the need for careful financial management, particularly for Pure CS companies facing higher costs and lower profit margins. By understanding these dynamics, executives can make more informed decisions about investments in climate solutions, balancing short-term profitability pressures with long-term growth opportunities in an increasingly climate-conscious global economy.
References
[1] Shirley Lu and George Serafeim, “The Financial Anatomy of Climate Solutions: A Large Language Model Approach to Company Classification and Analysis” Harvard Business Working Paper No. 25-026, Harvard Business School Accounting & Management Unit Working Paper 25-026 (August 22, 2024): 1-88, 4.
[2] Lu and Serafeim, “The Financial Anatomy of Climate Solutions: A Large Language Model Approach to Company Classification and Analysis”, 6.
[3] Lu and Serafeim, “The Financial Anatomy of Climate Solutions: A Large Language Model Approach to Company Classification and Analysis”, 5.
Meet the Authors
Shirley Lu is an Assistant Professor in the Accounting and Management Unit. She teaches the Financial Reporting and Control course in the MBA required curriculum. Professor Lu earned a PhD in accounting and an MBA from the University of Chicago. She earned a BS in accounting and finance, and a MS in accounting, both from New York University.
George Serafeim is the Charles M. Williams Professor of Business Administration at Harvard Business School, where he co-leads the Climate and Sustainability Impact Lab within the Digital, Data, and Design Institute. He teaches the MBA course “Risks, Opportunities, and Investments in an Era of Climate Change” (ROICC), which he developed to guide students in mastering the skills needed for entrepreneurial, managerial, or investment roles in a rapidly evolving climate landscape.