Financing a low-carbon revolution

Only a rapid transition to a low-carbon economy will prevent dangerous climate change and its catastrophic consequences. Conventional approaches to climate change mitigation emphasize the roles of international treaties such as the Paris Accord, action by national governments, and sub-national initiatives by cities and others. Until recently, these conventional approaches have failed to recognize the central importance of the financial sector in facilitating a rapid and deep low-carbon transition. Not only does the financial sector have an exceptional capacity to accelerate climate change action, but it interacts with all other sectors and exerts an increasing influence over many of them.

However, the task of transforming the financial sector from a high- to a low-carbon trajectory is a daunting one that will require vast amounts of finance: an estimated $93 trillion in US dollars by 2035 (UNESCAP 2017)) for climate action, much of which only the private sector has the wherewithal to provide. Scaling up “climate finance” – for low-carbon infrastructure, renewable energy, energy efficiency, and other mitigation measures – would involve transforming a sector that has only recently begun its journey toward sustainability. What will be needed is nothing short of a quiet revolution involving massive investments now in long-lived, low-carbon assets and in infrastructure that is resilient to the physical impacts of global heating – in tandem with new business models, extensive innovation, and new technologies.

What might prompt a shift in risk perceptions such that institutional investors become willing to invest in low-carbon and climate-adaptation projects on an enormous scale (while simultaneously withdrawing from fossil fuel investments)? How might a wide range of financial institutions be incentivized to address climate risks across the financial system? How might a radical shift in the flow of capital in the five principal asset classes – securities (including fixed income and equity), banking, investment, insurance, and systemic actions (those that affect more than one asset class) – be precipitated? The answers lie in greater disclosure of climate change information, improved climate risk management and disclosure, the imposition of risk weightings and capital requirements to disincentivize high-carbon investments, and mechanisms targeted at changing corporate culture and addressing short-termism.

Why the free market and “first-best” solutions aren’t enough

Neo-liberals argue that the free market alone will be capable of achieving the public interest in this sphere, as in many others. In the neo-liberal view, markets are inherently stable and self-correcting; market participants behave rationally; lending institutions have a self-interest in protecting shareholders’ equity; and there is little need for government intervention. However, the real world departs radically from the assumptions made by free-market ideology. As the global financial crisis of 2007-2008 made clear, financial markets require regulation more than most others because, left underregulated, they can and do cause profound economic and social harm.

The failures of the market to address climate change suggest the importance of government intervention, but what form of intervention will be most appropriate is much debated and highly contested. The theoretical “first-best” response to climate change would involve governments imposing a price on carbon (perhaps combined with a withdrawal of fossil fuel subsidies and an injection of research and development funding for innovative low-carbon technologies). Taxes, as conventional economic analysis points out, are both powerful and efficient, because they allow firms and households to find the lowest-cost ways of reducing their carbon footprint.

But first-best solutions such as carbon pricing are rarely politically acceptable. Political cycles are short, which inclines politicians to prioritize short-term projects and goals over long-term security. Moreover, the imposition of new taxes is rarely popular with voters (and the higher the tax, the greater the resistance), and vested interests, including the fossil fuel industry, often exercise considerable power behind the scenes.

A next-best option

The limited traction of first-best options suggests the need to explore the viability of second-best options. Crucially, unlike the former, which are almost entirely the prerogative of elected governments, some of the latter might be developed and implemented by parts of the state that have relative autonomy and are far less influenced by the constraints identified above. Such is the case with the financial sector. Here, the entities best capable of pulling many of the principal policy levers are central banks and financial regulators.

Moreover, given that climate change will have profound economic consequences with both prudential and systemic risk-management implications, central banks and financial regulators have considerable skin in the game: A “disorderly transition” could prompt global losses on the order of $20 trillion in US dollars, more than enough to trip the global financial system into crisis and likely collapse (Breeden 2019). Central banks could be pivotal in underpinning and accelerating a low-carbon transition, via both monetary policy and financial regulation, given their capacities to build financial-system resilience, protect it from shocks, and mitigate future climate risks.

Nevertheless, some critics question whether it is appropriate for these financial entities to engage with climate change risks, unless democratically elected governments explicitly direct them to do so, given that such intervention is not explicitly provided for in their mandates. For such reasons, central banks have traditionally been reticent to embrace social or environmental objectives in their decision-making criteria, although in emerging economies they have often taken a more expansive role. However, the global financial crisis and its aftermath saw central banks adopt a much more ambitious approach.

The climate threat to central banks

A turning point was when then-governor of the Bank of England Mark Carney and his colleagues scanned the horizon in 2015, seeking to identify where the next global financial crisis might come from, and concluded that climate change presents the greatest systemic risk to the global economy (Carney 2015). Carney and his colleagues identified three types of climate risk: physical risk (such as the impact of extreme weather events on the insurance industry, and the disruption of global supply chains on the economy); transition risk (the risk that fossil fuel investments suddenly plummet in value and become “stranded assets,” and more generally, the risk of a disruptive rather than an orderly low-carbon transition); and liability risk (the risk of organizations being sued for carbon pollution).

Of these three risk types, transition risk is the most likely to keep central bankers awake at night. If, for example, coal mines suddenly become stranded assets as panicked governments abruptly impose a high carbon price, this could prompt global losses of such a magnitude as to tip the global financial system into crisis.

Carney and the Bank of England were also clear that central banks can and should play a central role in addressing climate risks, given their responsibilities for ensuring financial and macroeconomic stability. In this, Carney has not been alone. For example, President of the European Central Bank Christine Lagarde has pledged that climate change is a “mission critical” for the bank (Randow and Skolimowski 2020). Similarly, France has positioned itself as a leader in climate finance (Paris Financial Center 2019), and the Canadian Expert Panel on Sustainable Finance has made clear that “climate-related risks are a source of financial risk and that relevant financial institutions and supervisors need to develop analytics and supervisory approaches to manage these risks” (Expert Panel on Sustainable Finance 2019, 24). China’s Guidelines for Establishing a Green Financial System also seek to mobilize and incentivize capital toward green investments.

Closing the information gap

Recognizing the threat that climate change presents to financial stability and much besides, the next question became: What roles might central banks and financial regulators play in reshaping the behavior of multiple market actors to accelerate the flow of climate finance? Crucially, when the Bank of England engaged with institutional investors and companies on climate risk, it found that markets were not factoring such risks into their decision-making, seemingly because they lacked adequate information. The available information was piecemeal, of variable quality, and did not facilitate comparison between different enterprises. Unsurprisingly, neither investors nor companies were much influenced by such disclosures – and in the absence of credible information, climate risks were seriously under-priced.

This recognition of severe informational deficits led the G20’s Financial Stability Board, at Carney’s prompting, to establish a Task Force on Climate-related Financial Disclosures. As is well known, the task force concluded that companies should disclose the risks and opportunities presented by climate change and their strategies for addressing them, with a focus on risk management (Task Force on Climate-related Financial Disclosures 2017). Fully informed investors, so it is assumed, would understand the risks of holding high-carbon assets in a climate-constrained future and would gravitate to low-carbon alternatives as a matter of self-interest. Or they would put pressure on high-carbon companies in which they were invested, to shift their business to a lower-carbon trajectory.

However, it is doubtful that the task force’s recommendations, even if mandated, will prove to be a game changer. On the contrary, it may well be that this framing has lulled policymakers – and central banks in particular – into a mistaken sense that information disclosure and risk management is all that is necessary to enable financial actors to play their part in a low-carbon transition.

Unfortunately, there is considerable evidence that the current measures are likely to be insufficient, because information and risk management mechanisms have their own limitations. First, holders of high-carbon assets have an incentive to understate their carbon footprint, and regulators encounter severe challenges identifying such misrepresentations. Second, risk management disclosure is similarly susceptible to manipulation by reporting entities that have a disincentive to reveal their vulnerabilities. Accordingly, some are likely to present themselves as having advanced climate-risk-management policies when their actual practices are far less impressive. Finally, financial market actors are short-sighted animals: They are often captive to the tyranny of quarterly returns, constantly fearful that if their short-term performance flags, there will be no long term to look forward to. Whether, as Carney and the task force hope, information disclosure will be sufficient to overcome these problems, is at best an open question.

Other mechanisms for risk mitigation

None of this is intended to suggest that the task force recommendations are unimportant, but rather that they need to be complemented by other mechanisms. But what might those be? Various options have been mooted. Toward the top of most to-do lists are proposals to prescribe different risk weightings and capital requirements for “green” and “brown” assets, thereby making it more expensive and otherwise disadvantageous to obtain finance for fossil-fuel-intensive initiatives. For example, a bank lending to facilitate the development of a coal-fired power plant would be required to hold more capital (as a measure of financial strength) than one lending to finance a wind farm.

In a low-carbon transition, many brown assets will lose value for a variety of reasons: Green technologies will improve and out-compete them; governments will intervene to impose a price on carbon or other mechanisms that disadvantage brown assets; and fossil fuel assets may become “stranded” in a disruptive low-carbon transition. Requiring financial institutions to have a capital buffer to absorb losses in circumstances where the value of brown assets may drop substantially, would be prudent. Raising risk weights for brown assets would have dual benefits: strengthening the capital base of banks and increasing the resilience of the financial system while also discouraging lending for high-carbon investments.

A change in weighting might also result in banks charging higher rates for brown assets, thereby making loans for carbon-intensive activities more expensive – and low-carbon alternatives more attractive. A more radical extension of such a policy would be to impose ceilings or quotas on brown credit and/or to establish minimum levels of ownership of green assets.

Another priority might be mechanisms directed to reducing the short-termism that many critics identify as the most fundamental obstacle to a low-carbon financial market revolution. Such mechanisms must be directed to changing culture, governance, and remuneration, none of which are easy targets. For example, incentive packages – particularly those of analysts and portfolio managers, in the case of institutional investors – might mandatorily be linked to the expected time horizon of the investment, with a larger portion of the overall incentive escrowed to align with the conclusion of the expected time horizon. Financial-services entities might also be required to take proper steps to assess the entity’s culture and its governance, and to address problems identified in that process.

In almost all jurisdictions company directors have a fiduciary duty to consider and respond to any risk that might apply to their company (a “due diligence” obligation). However, for the most part, corporate board members have not imagined that this duty extends to climate change. This too needs to change. Financial regulators have started the ball rolling, emphasizing that directors, in order to act in the best interests of their company, must take account of climate-related risks. However, jawboning is unlikely to be enough to shift corporate attitudes sufficiently. It may well take high-profile court actions against directors who have demonstrably failed to discharge their fiduciary duty as it applies to climate change, to drive this message home.

Fast-tracking a financial revolution

There is no shortage of other policy tools that might potentially be used to fast-track a low-carbon financial market revolution. As the International Monetary Fund has pointed out, monetary instruments to promote climate finance include better access to central bank funding schemes for banks that invest in low-carbon projects, central bank purchases of low-carbon bonds issued by development banks, credit allocation operations, and adapting monetary policy frameworks (Oman 2019).

Turning to the financial policy side, Oman identifies potential tools as including “reserve, liquidity and capital requirements, loan-to-value ratios, caps on credit growth, climate-related stress tests, disclosure requirements and financial data dissemination to enhance climate risk assessments, corporate governance reforms, and better categorization of green assets by developing a standardized taxonomy” (Oman 2019).

Financial markets have a vital role to play in achieving a rapid transition to a low-carbon economy. If they fail to embrace that role, the risk of catastrophic climate change appears ever more likely. Since markets alone will not provide the necessary incentives for action of the magnitude that is required, or within the short window of opportunity that remains, governments must act. While imposing a price on carbon is essential, political constraints have precluded strong action. Central banks and financial regulators must step into this policy vacuum. By pulling various well-designed policy levers they could make a powerful contribution toward delivering a low-carbon and climate-resilient economy.

If they fail to do so, or if they do “too little too late,” then one of two scenarios is likely to play out. In the first, climate change becomes unstoppable and extreme, with dire consequences for our species and many others (IPCC 2018). In the second, there is a “disorderly transition” in which markets, confronted by extreme climate events and a panicking political class, belatedly react, prompting a massive sell-off of carbon-intense assets. Such a transition is anticipated to cause a financial market collapse far worse than that experienced during the global financial crisis. To avert these scenarios, central banks and financial regulators must act soon and decisively.

Disclosure statement

No potential conflict of interest was reported by the author.

Funding

This research received no specific grant from any funding agency in the public, commercial, or not-for-profit sectors.

References

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