The prevention of catastrophic global warming is probably the biggest challenge of our generation. To avoid global temperatures rising by more than 1.5–2°C relative to pre-industrial times, as set by the Paris Agreement, we must urgently and systematically reduce global emissions of greenhouse gases (GHG), primarily Carbon Dioxide (CO2). According to the scientific community, the accumulating concertation of GHG in the atmosphere is the main cause of global climate change. If we want to sustain a habitable planet, the human-made release of GHG needs to peak, decline and turn zero as early as possible.
Unfortunately, current global emissions — which have continued to grow in 2019 — indicate that we are not remotely close to meeting the 2°C target, not to mention the 1.5°C best-scenario. Yet, this is not a reason for despair or abandon attempts to mitigate emissions. On the contrary, the faster we overhaul our fossil-fuel economy and stop piling up GHG in the atmosphere, the less damage future generations will suffer.
Transitioning to a low-carbon (and eventually, carbon-free) economy requires a tremendous and unprecedented effort, commitment and engagement from multi-stakeholders. The good news is that in many industries, innovators are coming up with fresh ideas to disrupt traditional CO2-intensive practices. The energy and transportation industries are experiencing dramatic transformation thanks to breakthroughs in clean and cheap alternatives like renewable energy and electric vehicles. However, in other industries like agriculture, cement, steel, and petrochemicals — which are also major (and often overlooked) sources of emissions — there is much less needed progress.
But one important industry which is crucial to the climate effort is still largely missing from the discussion: the finance industry.
The basic function of the financial industry is to allocate resources. It takes value from the present (“savings”) and transforms it into the future (“investments”), thus influencing human behavior and helping managing risks. The financial system could channel value to investments that maximize returns on clean, safe and green technology. Ideally, it could massively fund carbon-free projects that will help mitigate future emissions — solar and wind energy, electric transportation, and meat alternatives. It could help sponsor adaption measures to cope with harsher climate conditions, such as drought-resilient crops or rising sea-level housing protection; or it may explore the emerging world of negative emissions technology, a set of potential solutions to capture and remove CO2 from the atmosphere.
By all accounts, funding carbon-free alternatives is not going to be cheap. According to the UN’s Intergovernmental Panel on Climate Change (IPCC), an estimated annual investment of around 2.4 trillion US dollars — a 2.5% of world GDP — is needed in the energy sector alone until 2035 to limit warming to 1.5°. While that sum is not marginal, it may pale in comparison to the costs of business-as-usual emissions trajectory. And it cannot derive only from public and no-profit investments: institutional investors managing trillions of clients’ assets will also play their part, either alone or in partnership with the public sector (especially in investments with high uncertainty and risk-return profile). Together, agents in the financial system, regulators and firms alike, can play an active and prominent role in the global efforts to accelerate the transition to a low carbon economy.
But how can this be done?
In a recent speech at the UN Climate Summit in September, the Governor of the Bank of England, Mr. Mark Carney, outlined the role of the financial system. Carney outlines three ways in which the financial system can accelerate the transition: climate disclosure, climate-related risk management, and sustainable investment management. Although Carney addresses the financial system as a whole, all three are basically policy goals that can be encouraged by regulators and policymakers (either by voluntary incentives or binding regulation if necessary). In the following paragraphs, we are going to present each goal and see how it can be relevant in the global efforts to act on climate.
Let’s take a look at each part.
- Disclosure.
Effective policy to address climate risks can begin with disclosure. Financial institutes and public-held companies must identify, evaluate and describe their exposure to climate-related risks and opportunities, and explain how these possible scenarios can affect their business performance.
As the risks of climate change materialize and become more present, the demand for disclosure is growing.
In a world of calamitous natural events such as rising sea levels, extreme weather, droughts and natural disasters, climate disclosure is becoming ever more crucial. Investors should receisve sufficient information to understand how climate risks might affect their invested wealth — for example, real estate companies should describe how much of their portfolio is located in geographic areas that are likely to be affected by rising sea levels.
Also, given the growing demand for clean energy technologies, companies should provide investors the necessary information to make informed investment decisions. Specifically, they should also be aware of the risks associated with investments in carbon-intensive “brown” sectors like oil and coal. Recent research suggests investors are taking disclosure seriously, charging a premium from companies with significant carbon footprint and favoring companies with extensive disclosure. At the same time, financial regulators should monitor how these risks might hurt financial stability and cause future shocks and crises.
Encouragingly, climate disclosure is already gaining traction. In July 2017, the Task Force on Climate-related Financial Disclosures (TCFD), a business-led initiative supported by the G20, released a proposed framework for recommended disclosure items. The framework nudges companies to include comprehensive information in their annual statements on the governance, strategy, risk management and metrics used by the organization to address climate-related risks.
Comparing to the bleak news cycle of the climate sphere, the adoption of TCFD is a relative success. A fifth of over 1,100 top G20 companies have already implemented parts of the disclosure recommendations in their filings. Supporters and early-adopters of the framework include leading banks, asset managers, pension funds, insurers, credit rating agencies, accounting firms and shareholder advisory services, covering nearly $120 trillion of assets. This is yet another sign of the growing importance of climate impacts for investors and their stewards.
Yet, some believe it is far from enough. Carney thinks the frameworks should be mandatory. Some countries such as the UK and France have indicated their intention in this direction. If climate disclosure requirements are to become statutory, regulators must ensure it should be standard and coherent, to allow investors to compare effectively between companies’ emissions outputs and other indicators.
2) Risk Management.
Another essential tool is risk management. Since the financial crisis of 2008–9, prudential regulators (i.e., stability-focused) are dedicating a lot of energy for ensuring that large, too-big-to-fail financial institutions could survive turbulent times. Stress-testing had become more thorough and invasive, while international standards like Basel III and Solvency II were toughened to make banks and insurers more resilient in the face of future crises.
According to Carney, providers of capital and “those who supervise them” should develop similar models and methods to deal with climate-related scenarios. Asset valuation and risk management need to respond to the consequences of a warming planet: changes to physical infrastructures, scarcity of natural resources, adoption of new technologies and elimination of old ones. Regulatory frameworks should translate these realities to quantitative data that is used to determine the value-at-risk of investment portfolios.
Specifically, Carney is worried about the over-exposure of banks to “sunset sectors” like Coal and Oil. Over time, securities of carbon-intensive companies that don’t make the necessary transition will be viewed as toxic assets. Or as he simply puts it: “Companies that don’t adapt will go bankrupt”.
Carney says the Bank of England has just set out its supervisory expectations for climate risks management. The BoE will be the first regulator to stress test the UK’s financial system against climate scenarios, integrating climate models with macroeconomics and financial analysis. In April 2019, the Network for Greening the Financial System (NGFS) — comprising 42 central banks and financial regulators overseeing two-thirds of systemically important banks and insurers — called upon regulators in other countries to adopt similar tests to explore resiliency to climate risks. Here also, a coordinated international approach will be necessary.
3) Investing.
This is the most challenging and perhaps controversial policy target [1]. It aimes to encourage and incentivize investments in companies that are leading the efforts to reach zero-carbon economy, and penalize the one who does not. Encouraging sustainable investment is aimed to create a regulatory infrastructure that facilitates channeling of funds to the former instead of the latter.
The first way to do so is to have a coherent definition of “sustainable” investing. The idea of Environmental, Social and Governance (ESG) investments have gained large popularity in the recent, with institutional and retail investors pressing senior management to receive high ESG ratings. But, there is currently an inconsistent measurement of ESG that makes it complicated for companies and investors alike.
Financial regulators could bring a more clear and useful taxonomy of green stocks and bonds, as a public good for investors and companies who want to rely on it. According to Carney, the definition shouldn’t be binary (“green” vs. “brown”) but more rich and granular — determining the level of “ESG-ness” based on many criterions. Regulators could adopt an international framework for defining and measuring the carbon impact of investments, based on metrics like CO2 emissions, investments in low-emissions alternatives or rate of technology adoption.
Green bonds have already grown in volume, rising from less than $1 billion in 2009 to $177 billion in 2018. But other tools can also be developed. The Climate Finance Leadership Initiative, a group of senior executives of leading institutes such as Goldman Sachs and HSBC, points to a broader set of capital markets instruments, such as transition bonds or sustainability-linked corporate bonds, that can be useful to accelerate carbon transition. Regulators can support these efforts by creating frameworks that incentivize these investments. A new green bond model by the Danish government to increase liquidity (by separating between financial and non-financial obligations) offers a glimpse of innovation and ingenuity in the field.
Summary
The financial system can be a forceful catalysator in the joint mission of reaching a zero-carbon economy. Regulators and policymakers have a set of tools that, if applied wisely and effectively, can facilitate this aim. Disclosure, risk-management and investment infrastructure are all established mechanisms within the realm of financial regulators, which can be useful alongside other efforts to address climate risks and opportunities. Applying these tools in the context of the climate crisis serves not only the integrity of the financial system but also the general interest of human civilization, in one of its most challenging periods in history.
Eden Lang (Adv.) is an attorney in the Israeli Securities Authority specializing in financial regulation and technology. The views expressed in this post are his own and do not necessarily reflect the organization’s policy.
[1] Some may question if financial supervisors should actively be encouraging particular kind of investments, arguing it goes beyond their traditional regulatory mandate. While this question begs a deeper discussion over the role of regulators, for the purpose of this article it is suffice to say that they should make sure that investors who wish to encourage green investments should have the necessary tools to pursue their preferences.
