Bank regulators offer hope on climate change but must go further

Chris Hart

Our economy relies on natural resources, yet these are not valued and the financial risks are not recognised, Photo by Nicole Harrington on Unsplash

Last week the newly formed ‘coalition of the willing’ under the guise of the Network for Greening the Financial System (NGFS) launched a new report with recommendations to galvanise action on climate change by the global financial system.

The report highlights the growing risks to the financial sector from climate change as well as greater willingness for financial market regulators to intervene. But in limiting the scope of action to climate change only, ‘the coalition of the willing’ is restricting its ability to prevent a sudden and major collapse of asset values in financial markets.

In not recognising the wider destruction of nature caused by our current economic system — pollution, water scarcity, soil degradation, biodiversity loss, regulators are failing to address the full extent of the risk in the financial system.

Climate change just one symptom of broader market failure

Climate change is unquestionably one of the biggest market failures of modern times. Over the last 30 years, since the IPCC first brought the reality and dangers of climate change to our collective awareness, global average temperatures have remained on course to rise over 3oc from pre-industrial levels.

While the causes are complex, at the heart of this market failure is what the Governor of the Bank of England so memorably called the ‘tragedy of the horizon’. The longer-term and inter-generationally irreversible effects of climate change are lost amid the shorter-term return-maximising culture of the financial sector. This has resulted in 30 years of allocating vast amounts of capital to activities that have exacerbated climate change.

But climate change is only one aspect of this broader market failure. For decades, capital has also been allocated to projects that have unsustainably depleted global stocks of natural capital because the true value of nature has been systematically under-priced. This has resulted in significant environmental challenges such as rising fresh water scarcity, widespread soil degradation and exponential rates of biodiversity loss.

Wider environmental symptoms also pose systemic risks

Unsustainable use of nature is estimated to cost the global economy around $4.7 trillion a year in terms of lost ecosystem services and pollution. We are already consuming natural resources faster than they can be replenished but expansion in global human population and economic output will only put greater strain on nature’s ability to sustain such growth.

Business as usual without reform of how businesses use nature to produce goods and services threatens to bring about sudden downward step-shifts in the availability of ecosystem services on which our economy relies and is raising the vulnerability of the global financial system.

For example, billions of dollars of finance a year is required to feed the world. Crop production to meet this demand is reliant on rainfall and irrigation as well as healthy soils and a wide range of pollinators to produce reliable harvests.

The banks, investors and insurers that will provide the finance for this agricultural production are therefore reliant on nature to ensure expected returns on, and of, capital are achieved long into future. Yet if we continue with business as usual we threaten further depletion of the natural capital that the financial sector is reliant on to make its returns.

These challenges are not just isolated to the agricultural sector. Many sectors and the supply chains that link to them are potentially affected too. By looking more broadly across the economy the scale of finance at risk rises to the US$ trillions. If we don’t radically reform the way we produce goods then a systemic financial shock awaits us somewhere out in the not so distant future.

So by focusing on just climate change, to which deforestation and soil degradation are significant contributors, regulators of the global financial system are only addressing part of the problem. And successfully reducing greenhouse gas emissions by 2050 may not be enough to avert a systemic financial shock.

Regulators must demonstrate willingness to act for all of nature

Dealing decisively with these systemic and potentially existential risks will require a significant and rapid transformation of the business as usual approach that still dominates our current political, regulatory and financial sector thinking.

The Network for Greening the Financial Sector does though offer up grounds for hope. With 34 central banks and supervisors providing oversight for two thirds of the world’s systemically important banks and insurers, the membership has the power, and seemingly the will, to enable meaningful change.

And while much of the content of the recommendations contained within the report points to the importance of sector wide cooperation and collaboration, there is also a clear message on the future direction of travel: either the financial sector accelerates the re-allocation of capital to a low carbon economy without regulatory intervention, or regulators will ultimately force them to shift.

The work of the Network for Greening the Financial Sector is a logical and welcome next step in building momentum for global environmental legislation and financial sector oversight on systemic risks. Its focus on climate change at this stage in-part reflects the necessity for immediate action now to help mitigate the longer-term impacts of higher average global temperatures in the future.

But this same logic applies for action on natural capital. Unsustainable depletion of natural capital also poses a significant risk to the global financial system. The Network for Greening the Financial System has the ability to bring about the changes needed to avert the worst impacts from slow reform of business as usual, but it needs to act now.

Find out more about how the Natural Capital Finance Alliance (NCFA) supports financial regulators and the financial sector in better understanding risks by assessing the impacts and dependencies on natural capital across different economic sectors at www.naturalcapital.finance and www.encore.naturalcapital.finance.