ESG Carrots and Climate Sticks: Evaluating the Roles of Mandates and Incentives in Climate Financial Regulation

By | July 14, 2020

This post is the latest in our special issue: “Climate Change and Financial Markets – Risk, Regulation, and Innovation.” To learn more about the special issue and the work of the Global Financial Markets Center around climate change and financial markets, please read the special issue’s introduction here. And to review all The FinReg Blog posts that touch on climate change, go here.


The scientific consensus on climate change is clear: carbon emissions must be radically reduced, if not eliminated, in order to sustain the future of life on this planet.[1] Achieving this goal requires us to close the gap between the energy that we produce using fossil fuels and the energy we produce from clean sources. Eliminating the massive disparity in finance capital that still flows into dirty energy, often at the expense of green alternatives, is one of the keys to closing this production gap.[2]

Reaching net-zero greenhouse gas emissions will be especially difficult, if not impossible, so long as the largest private financial institutions are allowed to continue making investments that dwarf their clean energy commitments.[3] The largest U.S. financial institutions – banks, insurers, and asset managers – continue to be major financiers of the industries driving climate change through lending, underwriting, investing, or some combination of these activities.[4] Despite lofty rhetoric, and some modest steps,[5] industry-led efforts are not meeting this moment, as evidenced by facts ranging from the fossil fuel investments of the largest financial companies largely increasing since the signing of the Paris Accord,[6] to so-called “green bonds” making up less than 0.2% of debt securities issued globally as of 2017.[7]

Ultimately, it is policymakers who must address the role of the financial sector in supporting the fossil fuel industry, but there is still a disconnect between the potential threats from climate change and the actions of financial regulators in the U.S.[8] This is likely the result of a view amongst policymakers that the financial industry’s climate issues are largely the provenance of environment, social, and governance (ESG) practices.[9] Regulatory policies that treat climate change as an issue of corporate social responsibility (CSR) are insufficient because they approach climate financial risk as an ancillary risk, rather than an existential threat to the financial system—and the planet.[10]

In reality, the climate crisis is sowing the seeds of a potential financial crisis, and is therefore a significant source of vulnerability for large financial institutions, financial markets, and communities throughout the country. As a result, there is a significant risk that we could experience a “climate Lehman moment,” meaning a systemic financial event, driven by climate change, that is exacerbated by the actions, or lack thereof, taken by financial institutions and regulators.[11] In this post, I will argue that the scope and urgency of the threats to the planet and the financial system cannot wait for incentives to gradually nudge financial industry behavior. I will begin by making the case that climate-focused mandates are both necessary and appropriate for financial policy makers. Then I will provide examples that illustrate why we cannot meet our climate goals without financial policies that rely on government-driven, mandatory reforms.

The Importance of Mandates

Mandatory action is both necessary and appropriate because climate change-causing financial activities create dueling negative externalities that expose the public to great risks and costs.[12] Climate financial risk produces two sets of potent negative externalities. The first stems from carbon pollution pumped into the air—the “canonical example” of an externality in economics textbooks—as “[p]olluting companies impose the costs of their activities on a usually unwitting public.”[13] The second arises from the financial costs created by climate change stressing individual companies, accumulating to threaten failures, runs, panics, and the distress that spreads from the financial system to the broader economy, resulting in public rescues of the financial system.[14]

Should they fail to act, public authorities may become the “climate rescuers of last resort.”[15] Unless climate risks are addressed through macroprudential regulations, climate reinvestment mandates, and the like, the confluence of these externalities will result in significant public costs. Such costs may include, but are not limited to, mitigating climate change-driven physical destruction, relocating large populations away from climate-damaged regions, as well as economic rescues in the form of aid packages for areas that rely on fossil fuels or deforestation and buyouts of investors in industries that are currently being propped up by the carbon bubble.[16]

Public expenditures to mitigate the damage of a climate crisis will essentially constitute a bailout if they provide any sort of windfall to shareholders and executives of the very companies currently driving the climate crisis at the public’s expense.[17] This would further exacerbate economic inequality, social unrest, and other economic, political, and social problems. Even worse, however, the traditional sources of monetary and fiscal support ultimately do nothing to alleviate the underlying climate problem, as large-scale asset purchases, quantitative easing, and other extraordinary measures have no ability to remove carbon from the atmosphere once it has been released.[18]

Whether we like it or not, the public is already heavily involved in the issue of climate finance. We charter the banks and other financial institutions that provide capital to dirty industries, from banks to asset managers. We are also implicitly backstopping both the financial risks and the climate risks that these institutions are creating. For those reasons, public authorities should play a more forceful role in shaping the industry’s response.

Climate Prudential Regulation

Prudential regulation of banks and other financial companies is the first example of a framework that presents us with a choice between incentives and penalties – one which poses significant tradeoffs.

To preserve the financial wherewithal of individual banks, as well as the financial system as a whole, banks are required to have minimum ratios of capital to assets to ensure they can withstand a certain amount of losses before their solvency is called into question. Some of these bank capital requirements, referred to as risk-based capital, are determined based on the real or perceived riskiness of assets. Other types of financial institutions use alternative measures to capital, like “solvency,” which are conceptually similar. There are two sets of proposed roles for capital requirements to play in addressing climate change: one that provides a capital reduction for assets tied to green energy sectors, and one that increases the risk factor for “dirty” investments. Here I want to take a moment to acknowledge that some of the existing language that has been used to describe this taxonomy, identifying “brown” investments as negative, is inherently racist, and that white people in particular need to change the way that they talk about and frame this issue.[19] Having said that, there are both policy reasons and empirical challenges that suggest that the proper approach, at least in the near term, is to increase the penalty for climate-driving dirty investments.

Risk-based capital rules are meant to be exactly that: risk-based. In this context, the foundation that clean investments are, in fact, less financially risky has yet to be established. Offering benefits solely for desirable policy goals would undermine the central purpose of capital rules and would decrease the resilience of the financial system.[20] Incentivizing green investments in the capital framework would transform climate risk from a financial risk-focused frame to a social goal that is divorced from an underlying empirical foundation. Indeed, one of the most salient criticisms of the risk-based capital regime is that it provides generous weightings to politically popular investments.[21] Even U.S. regulators who acknowledge the potential financial stability threats of climate change have cautioned that supervision should be limited to a “risk management perspective, not a social engineering one.”[22] Short of establishing a financial risk-based case to lower capital for green investments, the focus should be on mitigating the financial risks created by climate change.

A prudential, capital-based framework must be based on the premise that climate change is increasing the riskiness of certain financial assets,[23] but capital rules and regulations do not currently capture that risk. While the studies of data and modeling require further development,[24] capital rules can be updated on the basis of climate risk to reflect the potential for capital-intensive losses based on financial climate risks.[25] Capital requirements rely upon a system of “risk weights” for measuring an institution’s assets that make up the denominator in a capital ratio. A 100 percent risk weighting means a dollar-for-dollar representation of an asset in the denominator, and so on. Risk weights could be increased for loans and investments in climate change-driving assets, as well as credit exposures to sectors that are vulnerable to the effects of climate change.[26] These risk weights would apply, at a minimum, to all financing of the industries that encompass the industrial “carbon majors,”[27] as well as agribusinesses operating in areas that are sensitive to deforestation, to better reflect the true costs and risks from the climate impacts of these investments.[28]

Climate Reinvestment

In addition to addressing the role of financial institutions in creating climate risk, policy makers must also make communities more resilient to the effects of climate change. Recalibrating the potential risks of asset classes, communities, and entire geographic regions that are most vulnerable to climate change raises issues of socioeconomic and racial equity and inclusion. These measures must be part of a more comprehensive reinvestment plan that remedies the climate-related harms done to frontline communities and ensures these communities are being made more climate resilient. One means of achieving this goal is through community climate reinvestment.

The Community Reinvestment Act of 1977 requires financial regulators to “assess the [financial] institution’s record of meeting the credit needs of its entire community, including low- and moderate-income neighborhoods[.]”[29] The law is intended to ensure that banks demonstrate that their branches “serve the convenience and needs of the communities in which they are chartered to do business[.]”[30] The original view of the law was that it is broad and open to wide interpretation.[31] Regulators have the discretion to define significant terms in the law, including what it means to “meet the credit needs” of communities, including low-income neighborhoods.[32]

The focus of climate in the context of the CRA has largely focused on whether investments to make communities more climate resilient should be eligible to receive credit under the CRA.[33] This is another approach that relies on incentives rather than mandates – if a bank makes climate-friendly investments it gets credit, but if it makes harmful investments it is not penalized. Amongst other issues, this has the potential to crowd out other beneficial CRA investments.

A 2004 CRA update included a provision that “an institution’s evaluation will be adversely affected by discriminatory, other illegal, or abusive credit practices described in the regulation,” regardless of where loans and practices take place.[34] Banks are essentially penalized in their CRA ratings for fair lending violations. This is the relevant provision for thinking about another way that the impact of climate change financing could become a factor in CRA ratings.

The “disparate impact” theory, that the impact of credit practices can be used as a factor in measuring whether those practices are discriminatory, is prevalent in fair lending law.[35] Disparate impact can be connected to the concept of environmental racism and justice: climate change and pollution fall the hardest on communities of color, from pollution pumped out by plants to pipelines that are vulnerable to leaks and spills.[36] Rather than merely offering banks a benefit for funding good activities, regulators can penalize banks for the disparate impact of their decisions to fund climate change-causing activities on frontline communities. The design of this program will be important, as evidence suggests that incentive structures like state-level carbon pricing schemes have still resulted in environmental injustice and racism,[37] not to mention their demonstrated lack of effectiveness.[38]

CRA regulations have been updated based upon a variety of factors, in response to feedback and emerging trends and developments.[39] Indeed, one Trump administration regulator – the OCC – has reformed the CRA, referred to as “modernization.”[40] While this effort is badly misguided and will result in harms to some of the most vulnerable communities,[41] it is based in a truth that reinvestment mandates require some updating to reflect evolving understandings and societal conditions.

Conclusion: The Danger of Doing Nothing

There are other areas where the policy conversation should move away from incentives and toward mandates. For example, the Department of Labor recently proposed a rule to prohibit retirement plan fiduciaries from investing in funds if they understand those funds to prioritize ESG factors over financial returns.[42] Traditionally, the debate around fiduciary duties has vacillated between whether ESG investments are either permissible or impermissible; instead, it should focus on creating a standardized ESG definition and then making it a mandatory goal of investing. Similarly, the Securities and Exchange Commission could issue regulations calling for a mandatory climate analysis as part of the ratings process for corporate securities,[43] rather than discretionary ratings only available to certain interested investors. These are just a few ways to continue promoting ESG without conflicting with fiduciary duties.

The actions taken by financial institutions and other market participants largely depend on their incentives, namely the quest to maximize short-term profits, share price, and bonus payouts at the expense of long-term interests.[44] While there are isolated examples of institutions taking incremental steps to address climate risk,[45] many financial institutions—from banks[46] to insurers[47]—still fail to either fully account for the various financial risks of climate change, or take affirmative steps to fully mitigate such risks. Research suggests that such modest voluntary industry actions on the environment, sometimes referred to as “greenwashing,” may actually have the effect of forestalling substantive government regulations.[48] Indeed, in one example, financial institutions lag the rest of corporate America in implementing policies and practices around financing the commodities that drive deforestation,[49] the second leading cause of climate change.

As a result, the only truly effective approach to climate financial risk mitigation in regulators’ ambit is through mandatory preventative measures that run through a range of public institutions all working in unison toward a common goal.[50] As European Central Bank Governor Christine Lagarde responded when asked about the view that climate change is not the responsibility of central banks: “I’m aware of all that. I’m also aware of the danger of doing nothing.”[51]


Graham Steele is the director of the Corporations and Society Initiative at Stanford Graduate School of Business, and was previously on the staff of the Federal Reserve Bank of San Francisco.


[1] See H. Res. 109 (116th Cong.) (noting that the Fourth National Climate Assessment report found that avoiding the most severe impacts of climate change will require reducing greenhouse gas emissions by 40%-60% from 2010 levels by 2030, and net-zero global emissions by 2050).

[2] M. Lazarus, C. Verkuijl & E. Yehle, Closing the Fossil Fuel Production Gap, Stockholm Env’t Inst. (2019),

[3] See Network for the Greening of the Fin. Sys., A Call For Action: Climate Change as a Source of Financial Risk (Apr. 2019), available at:

[4] See Rainforest Action Network, Banking on Climate Change, at 7 (2019) (from 2016-2018, six of the eight largest U.S. bank holding companies loaned, underwrote, or otherwise financed over $700 billion to fossil fuel companies),; see also Int’l Ass’n of Ins. Supervisors & Sustainable Ins. Forum, Issues Paper on Climate Change Risks to the Insurance Sector, at 66-67 (July 2018) (citing a 2016 California Department of Insurance data call finding insurers with over $100 million in premiums reported $528 billion in fossil fuel-related investments),; see also Patrick Greenfield, World’s Top Three Asset Managers Oversee $300bn Fossil Fuel Investments, The Guardian, Oct. 12, 2019 (estimating the “Big Three” asset managers hold at least $287 billion in fossil fuel investments),

[5] See, e.g., Thomas Biesheuvel, Big Coal Escapes BlackRock’s New Climate Plan, Bloomberg, Jan. 14, 2020,; see also Russell Ward, Goldman Sachs Curbs New Lending on Coal and Arctic Oil, Bloomberg, Dec. 15, 2019,

[6] See Rainforest Action Network, supra note 4, at 4 (the six largest US banks are responsible for 37 percent of global fossil fuel financing since the signing of the Paris Agreement, with the amount financed rising each year); see also Greenfield, supra note 4 (the potential CO2 emissions from the investments made by the “Big Three” asset managers have increased from 10.593 gigatons to 14.283 gigatons since the Paris agreement, equivalent to 38 percent of global fossil fuel CO2 emissions in 2018),; see also Patrick Jahnke, Holders of Last Resort: The Role of Index Funds and Index Providers in Divestment and Climate Change, at 5 (Mar. 9, 2019)(the largest asset managers increased their investments in carbon-intensive industries by 20 percent from 2016 to 2018), available at SSRN:

[7] See Victor Galaza, et al, Finance and the Earth System: Exploring the Links Between Financial Actors and Non-Linear Changes in the Climate System, 53 Global Envtl. Change 296, 297 (2018).

[8] Patrick Bolton, et al, The Green Swan: Central Banking and Financial Stability in the Age of Climate Change, at 42 (Bank for Int’l Settlements, Jan. 2020),

[9] See, e.g., Alexander Kaufman, Bank of America Touts Going Green but Funnels Billions into Fossil Fuels, Huffington Post, Sept. 20, 2016,

[10] See Bank of England, Transition in Thinking: The Impact of Climate Change on the U.K. Banking Sector 39, Sept. 2018,

[11] See Graham Steele, Confronting the ‘Climate Lehman Moment’: The Case for Macroprudential Climate Regulation (Feb. 22, 2020), Cornell J.L. & Pub. Pol’y, Forthcoming. Available at SSRN:

[12] See Anat R. Admati, Peter Conti-Brown & Paul Pfleiderer, Liability Holding Companies, 59 UCLA L. Rev. 852, 861 (2012) (negative externalities occur when “[p]rivate parties enjoy the benefits of inefficient activity because they do not have to bear the full cost of these activities.”).

[13] Id.

[14] See Daniel K. Tarullo, Member, Bd. of Governors of the Fed. Reserve Sys., “Confronting Too Big to Fail,” Remarks to the Exchequer Club, Oct. 21, 2009 (observing that “government authorities often believe they have little choice but to intervene” in a systemwide panic, and that the government “may provide funds or guarantees to the bank in order to keep it functioning”),

[15] Bolton, et al, supra note 8, at 9.

[16] As the risks of climate change become increasingly clear, private institutions may already be seeking to shift the financial burden to U.S. taxpayers. For example, the United States has $600 billion in real property value located within one mile of the coast, currently covered under the National Flood Insurance Program, but which will not be viable in coming decades absent intensive investments in climate adaptation. See Int’l Ass’n of Ins. Supervisors & Sustainable Ins. Forum, supra note 4, at 17. In addition, one study suggests that mortgage lenders in areas hit by billion-dollar climate events do not stop lending in those areas following such events, but rather shift mortgage risk via securitization to the taxpayer-backed government sponsored enterprises (GSEs). See Amine Ouazad & Matthew E. Kahn, Mortgage Finance in the Face of Rising Climate Risk, NBER Working Paper No. 26322 (Sept. 30, 2019).

[17] See Lamperti, et al, supra note 16 (as a result of climate-induce financial crises, “[r]escuing insolvent banks will cause an additional fiscal burden of approximately 5–15 percent of gross domestic product per year”); see Tarullo, supra note 125 (the prospect of government support means “management and shareholders of the too-big-to-fail institution may, in turn, regard themselves as holding a kind of put option” to the U.S. government).

[18] Bolton, et al, supra note 8, at 47 (a climate-driven financial crisis has a “key difference from an ordinary financial crisis, because the accumulation of atmospheric CO2 beyond certain thresholds can lead to irreversible impacts, meaning that the biophysical causes of the crisis will be difficult if not impossible to undo at a later stage”).

[19] See Rev. Lennox Yearwood Jr., “The Language of ‘Brown Finance’ in Climate Finance is Racist,”, June 26, 2020,

[20] See Campiglio, et al, Climate Change Challenges for Central Banks and Financial Regulators, 8 Nature Climate Change 462, 465 (2018) (“[T]here is the danger that reducing capital requirements on bank loans to low-carbon investments could jeopardize prudential policy objectives,” and because “the role of capital requirements is to mitigate risks; their design should thus remain risk-based.”).

[21] See Anat R. Admati, Containing the Debt Crisis, N.Y. Times Room for Debate, Jan. 8, 2014 (noting that Greek bonds received a zero risk weight under international capital agreements),

[22] Kevin J. Stiroh, Exec. V.P., Fed. Reserve Bank of N.Y., “Emerging Issues for Risk Managers,” Introductory Remarks at the GARP Global Risk Forum, Nov. 7, 2019,

[23] See Rhodium Group, Clear, Present and Underpriced: The Physical Risks of Climate Change 10 (Apr. 2019) (noting that climate change has made commercial real estate more vulnerable to high wind and flooding exposure, and higher energy costs),

[24] See Network for the Greening of the Fin. Sys., supra note 3, at 26-27.

[25] See Lamperti, et al, The Public Costs of Climate-Induced Financial Instability, 9 Nature Climate Change 829, 831 (2019) (“[C]apital requirements can counterbalance eventual excessive or reluctant credit provision, accounting for the impacts of climate damages on firms’ solvency.”); see also George Hay, Fiddling with Bank Capital Can Help the Planet, Reuters BreakingViews, Sept. 27, 2019,

[26] See, e.g., Marcelo Ochoa, et al, What Do Capital Markets Tell Us About Climate Change?, at 42, 2016 Meeting Papers 542, Society for Econ. Dynamics (2016),

[27] See Carbon Disclosure Project, CDP Carbon Majors Report 2017, at 8 (2017),

[28] See Campiglio , et al, supra note 14, at 464 (“Implementing a more comprehensive assessment of risk could instead lead to a higher capital requirement on carbon-intensive assets, in consideration of their higher transition risks”). The Network for the Greening of the Financial System has recommended “possibly consider integrating” updates to Basel 3’s capital regulations to account for climate risk. Network for the Greening of the Fin. Sys., supra note 3, at 23. No jurisdiction has done so to date, see id., at 26, and in fact some are delaying their efforts to stress test for climate risks amid the COVID-19 pandemic. See Alastair Marsh, Bank of England Postpones Climate Stress Tests to Focus on Virus, Bloomberg, May 7, 2020,

[29] 12 U.S.C. § 2903.

[30] 12 U.S.C. § 2901.

[31] See Akm Rezaul Hossain, The Past, Present and Future of Community Reinvestment Act (CRA): A Historical Perspective, at 13-14, Econ. Working Paper No. 2004-30 (2004),; see also id., at 14-15.

[32] Id., at 15.

[33] See, e.g., Jesse M. Keenan & Elizabeth Mattiuzzi, “Climate Adaptation Investment and the Community Reinvestment Act,” Fed. Reserve Bank of S.F. Cmty. Dev. Research Brief 2019-5 (2019),; see also Sarah Rosen Wartell, Executive Vice President, Ctr. For Am. Progress Action Fund, Statement Before the Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, Office of the Comptroller of the Currency & Office of Thrift Supervision, Joint Public Hearing on the Community Reinvestment Act Regulation, July 19, 2010, at 9-11 (arguing that “regulators should find ways to encourage financial institutions to ensure that … consumers and housing providers in their communities have access to credit to take advantage of the same clean energy innovations that high-income communities are rapidly adopting.”),

[34] See Hossain, supra note 25, at 74.

[35] See, e.g., Winnie F. Taylor, The ECOA and Disparate Impact Theory: A Historical Perspective, 26 J. L. & Pol’y 575, 577 (2018).

[36] See Vann R. Newkirk II, Trump’s EPA Concludes Environmental Racism Is Real, The Atlantic, Feb. 28, 2018,

[37] See Lara J. Cushing, et al, A Preliminary Environmental Equity Assessment of California’s Cap-and-Trade Program, Cal. Justice Alliance Research Brief, Sept. 2016,

[38] See Lisa Song, Cap and Trade Is Supposed to Solve Climate Change, but Oil and Gas Company Emissions Are Up, ProPublica, Nov. 15, 2019,

[39] See Hossain, supra note 32, at 25.

[40] See Press Release, “OCC Finalizes Rule to Strengthen and Modernize Community Reinvestment Act Regulations,” Ofc. of the Comptroller of the Currency, May 20, 2020,

[41] See Editorial, Don’t Undermine the Community Reinvestment Act, Bloomberg, June 11, 2020,

[42] See Dep’t of Labor, Employee Benefits Security Administration, 85 Fed. Reg. 39,113, 39,116 (June 30, 2020) (noting that the proposed rule is “designed in part to make clear that ERISA plan fiduciaries may not invest in ESG vehicles when they understand an underlying investment strategy of the vehicle is to subordinate return or increase risk for the purpose of nonpecuniary objectives.”).

[43] See 15 U.S.C. § 78o–7(d)(2)(B)(i). The role of credit ratings was found to be one of “systemic importance” and in the “national public interest, as credit rating agencies are central to capital formation, investor confidence, and the efficient performance of the United States economy.” Pub. L. No. 111-203, at § 931(1).

[44] See Anat R. Admati, A Skeptical View of Financialized Corporate Governance, 31 J. of Econ. Perspectives 131 (2017).

[45] See Biesheuvel, supra note 5; see also Ward, supra note 5.

[46] See, e.g., Bank of England, supra note 10, at 23 (“While many banks identified the potential impacts from physical risk factors on property and real estate, few identified the potential impacts from the transition.”); see also Rainforest Action Network, supra note 4, at 6 (“[B]anks’ clean financing is in any case swamped by the volumes they funnel into fossil fuels”).

[47] See Int’l Ass’n of Ins. Supervisors, IAIS Global Insurance Market Report 2017, at 22 (Feb. 27, 2018) (“A 2016 analysis found that nearly 60% of the 116 insurers surveyed recognise climate risk as an issue; however two fifths of these insurers are taking no action to adjust their portfolios.”),; see also Int’l Ass’n of Ins. Supervisors & Sustainable Ins. Forum, supra note X, at 22 (Eighty of the world’s largest insurers have combined assets under management of $15 trillion, and yet an average of only one percent of that is allocated to low-carbon investments).

[48] See Neil Malhotra, Benoit Monin & Michael Tomz, Does Private Regulation Preempt Public Regulation?, 113 Am. Political Science Rev. 19, 30-32 (2018).

[49] See Sarah Rogerson, Forest 500 Annual Report 2018: The Countdown to 2020, at 24, Global Canopy (2019).

[50] See Steven Mufson & Rachel Siegel, BlackRock Makes Climate Change Central to Its Investment Strategy, Wash. Post, Jan. 14, 2020 (quoting BlackRock CEO Larry Fink that, “We don’t have a Federal Reserve to stabilize the world like in the five or six financial crises that occurred during my 40 years in finance … This is bigger, it requires more planning, it requires more public and private connections together to solve these problems.”),

[51] Jack Ewing, Climate Change Could Blow Up the Economy. Banks Aren’t Ready, N.Y. Times, Jan. 23, 2020,

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