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.
European financial markets provide the credit and lending facilities required for businesses and the public sector in the European Union (EU) and beyond to function. Yet, these financial markets are also the channels through which unsustainable activities are funded. If the EU is to realize its own commitments to sustainability, it must address the funding of such activities.
Those commitments to tackling climate change in particular are prima facie impressive, and worthy of analysis. The EU’s Sustainable Finance Initiative (SFI), launched in 2018, promised to “connect finance with the specific needs of the European economy to the benefit of the planet and our society.” The European Green Deal followed in January 2020 with much fanfare. A Taxonomy of sustainable activities, developed by the Commission and the EU technical expert group on sustainable finance (TEG) has recently been adopted, in addition to the introduction of mandatory disclosure requirements of sustainability risk management by institutional investors, and rules on how indices used as the basis for sustainable investment products are benchmarked. These are the three crucial pillars of the SFI.
The Commission’s program relies upon private markets to deliver change and applies tried-and-trusted mechanisms in order to assist in the scaling-up of sustainable finance markets and secure financial stability. Such mechanisms are designed to provide higher levels of information, standardisation, and disclosure to private actors. The thinking goes that increasing information flows to investors and allowing them to compare products and instruments on a case-by-case basis will spur investment in these asset classes, in particular large institutional investors who have complained in the past that green financial product markets, such as those for green bonds, have been too opaque and prone to greenwashing. To this end, the EU has been proactive in facilitating the introduction of new financial products with ‘green’ credentials, taking a lead in developing such markets.
In spite of these steps, as we argue in our recent report from the EU-funded SMART Project, the EU’s efforts remain insufficient and deep challenges remain. In particular, the EU’s financial structure and budget rules – which prevent sustained deficit spending – make it difficult for states to commit funds to financing the sustainable investments needed to address climate change and other challenges threatening planetary boundaries. The recent pandemic has demonstrated that these rules may be relaxed in times of emergency, yet there is scant political will to embrace such measures in relation to climate change, in spite of the fact that the likelihood of deep and irreversible losses stemming from climate change is greater than that associated with COVID-19, perhaps by orders of magnitude.
The EU financial system
A key issue in discussions concerning climate change and financial stability in the EU context is its financial structure, which is dominated by banks. The banking sector provides 70 per cent of the external funding for small and medium-sized enterprises (SMEs) in the EU. Whilst other jurisdictions such as the United States, China, and Japan have developed deep capital markets, investment beyond the banking system within the EU—with the exception of France and the UK—remains underdeveloped. Indicatively, domestic bank credit in the euro area in 2012 amounted to 255 percent of GDP, compared to around 90 percent in the US. Because banks are by far the largest source of financial capital in the EU, the effects of their lending policies are magnified, posing risks to financial stability.
In addition, the EU banking system is also a heavy financier of fossil-fuel companies. Research shows that in 2019, of the top 33 funders of fossil fuel activities, fifteen were headquartered in the EU. Another recent report shows that the fifteen largest European banks, inter alia, still carry significant exposures to climate-related liabilities and risk; all (bar one) have no explicit objectives for decreasing such exposures; and none could accurately report on the ratio of high-carbon assets amongst their risk-weighted assets (‘RWAs’). Further research shows that over fifty percent of bank assets in the Euro area are exposed to climate change-related risks.
This means that EU banks are relatively more exposed than those in other jurisdictions to negative spillovers from climate shifts. In turn, any reforms to EU capital markets and the launch of market-based finance initiatives to promote green finance—for example, via the SFI—are likely to be limited in impact. The limitations of disclosure and transparency as regulatory techniques for example are well-established, particularly as such measures encourage an excessive-focus on market-driven solutions and cede the impetus for change to private investors. Predictions of potential financial losses from climate change are so speculative that disclosure will be essentially guesswork. Shareholders will be aware of this and will discount the information accordingly. Moreover, financial supervisors concerned about financial stability will have incomplete information upon which to base mitigation policies.
The uncertainty of climate change risks
As one of us has noted in a recent paper, most analyses of the dynamic between climate change and financial stability fail to capture the central property of the problem of climate change; namely fundamental uncertainty. Most discussions tend to focus either on the potential losses which the financial sector may be exposed to in the event of sudden shifts in regulatory policy, for example the ‘stranded assets’ debate, or, behavioral obstacles, such as short-termism, which render attempts to meet the EU’s own climate abatement goals difficult to achieve. If we instead focus on uncertainty, it becomes clear that even if financial markets were able to adapt their behaviour to climate externalities, there are deep structural uncertainties within climate science, combined with the inability to arrive at meaningful estimates of economic damage from climate developments—in essence, the presence of ‘Knightian’ uncertainty—which destroy the viability of probability estimates of future climate change impacts. The compounded effects of events in a non-linear system such as the global climate, in which small changes in one part of the system may lead to large, unpredictable effects in another, mean that environmental damages may be severely underestimated. In worst-case scenarios, the extreme downsides of large temperature changes are catastrophic. These impacts would ruin individual institutions and cause crises at the systemic level which no central bank could mitigate.
In the face of such calculus, the pressures placed on the market to correctly interpret the potential damages inflicted on the economy from climate change are insurmountable. Moreover, there is no mechanism with which investors and institutions may protect themselves from losses via countervailing policies, insurance or investment diversification to offset the risks involved to the value of their assets and future profitability. Some estimates place the levels of such ‘unhedgeable’ risk at around half of the total of potential impacts on financial asset values.
This uncertainty has led policymakers into a trap: because the anticipated costs of climate change are so uncertain, policy responses frequently frame the problem as one for other agencies to tackle, or lead to policy paralysis. This is particularly true of central banks, which regard their independence from so-called ‘political’ considerations as an unbreakable firewall which guards the democratic process. Reforms which essentially mimic or extend existing financial regulations regarding transparency levels and standardisation for green financial products will prove insufficient in the absence of any reliable risk calculations upon which to base capital allocation decisions. In these circumstances, financial institutions have few incentives to reduce their exposures to GHG-risky assets, even as prospective damages both to the financial system and wider economies remain unquantifiable. There is therefore a growing and potentially devastating financial stability risk inherent in the approach adopted to EU financial sector policy, although these lessons have much broader application.
Precaution as a policy guide
This critique provides important insights for high-level public policy and the use of regulation to combat climate change. In our report, we argue that what is required in relation to such efforts is the extension of a precautionary approach to any future financing of GHG-intensive industries. The precautionary principle (PP) imposes a burden of proof on those who create potential risks, and it requires regulation of activities even if it cannot be shown that those activities are likely to produce significant harms. In the legal sphere, it is employed most appropriately as a way to tackle uncertain risks. Importantly, in the case of risks of ruin, where there is no diversifying strategy, the principle becomes stronger in form. Such an approach is already adopted in a number of areas of European jurisprudence and provides well-established principles in the creation and interpretation of European legislation, particularly in the environmental and international law fields. It is also recommended for use in guiding regulatory policies on climate change. Given that EU Member States are parties to major international agreements on environmental regulation, including the Vienna Convention and the Montreal Protocol, which cite the precautionary principle as a founding principle, this provides propitious grounds for implementing a precautionary approach.
In our report, we argue that the extreme uncertainty which characterizes the consequences of unsustainability, together with the importance of the financial sector as an accelerant of climate damages, requires that far-reaching precautionary regulations are rapidly adopted. These measures are designed to mitigate financial flows to unsustainable activities whilst simultaneously enhancing financial stability. We contend that the existing ECB mandate permits directly the consideration of sustainability risks, because such risks constitute threats to financial stability. There is a good deal of research which supports this view. Most notably, both the Bank of England and De Nederlandsche Bank have argued recently that the role of central banks must be interpreted more broadly; specifically, to include climate and environmental risks into their respective financial system monitoring tools. Central banks have already started to explore how their actions (or inactions) might interact with climate-change and its role in financial stability. Arguably, this reflects the recognition that central banks are the only institutions with the financial capacity to effect and support meaningful change in this arena.
Thankfully, the EU has indicated that some of the options we have recommended are under active consideration. Our chief policy reform proposals are included below (our full list of proposals can be found here):
(i) Abandon the proposed EU green-supporting factor in bank capital regulation and replace it with an ‘harmful activity’ penalizing factor
The EU Commission plans to introduce a ‘green-supporting factor’ (GSF) under the Capital Requirements Regulation (CRR). Yet, evidence suggests that altering capital requirements downward would likely have a negligible effect on banks’ decisions on whether to make specific loans. Indeed, research indicates that the estimated effect is a reduction in capital requirements only associated with a GSF of around €5-8 billion.
In contrast, higher risk-weighted capital requirements are known to disincentivize lending, including when targeted at particular asset classes. Powers to amend lending in this way are already afforded to bank regulators under the CRR; such an option provides regulators with a flexible, targeted tool with which to funnel credit away from particular sectors, and thus decrease financial flows to such projects. Assuming a similar capital adjustment for the GSF (15-25%), the simulated effects are in the ranges of €8-13 billion additional capital requirements for a limited application and €14-22 billion for an expanded application. Even stronger adjustments, such as 50%, could lead to a €27-44 billion penalty. The main reason behind the stronger effect is the larger universe of high carbon assets compared to sustainable assets on which such a penalty would be applied. This will produce two socially desirable outcomes: increased (rather than lower) loss-absorbing capacity at financial institutions; and the internalisation of at least some of the costs of climate change.
(ii) Incorporate climate change risk explicitly into the stress-testing regime
Even if one assumes that financial risks of unsustainable economic activities can be modelled to some degree of accuracy, the foreseeable systemic risks from transgressing the planetary boundaries are significant. In joint research, the Carbon Tracker Initiative and Grantham Research Institute in 2013 showed, using the example of stranded assets, that at the prevailing capital expenditure of fossil fuel site and field development, at least $6.74 trillion would be wasted in developing reserves that are likely to become unburnable. In June 2020, BP announced that it was adjusting its balance sheet downward by up to $17 billion to account for stranded assets.
Under any stress testing regime implemented by the European authorities, input stressors into such tests should progress beyond those posed by so-called ‘transition risks’ that currently dominate debates on environment-related stress-testing. As noted above, the physical risks from climate change are both highly uncertain and fat-tailed; complete ruin scenarios are possible and, according to many climate models, non-negligible. These are precisely the circumstances in which stress tests are most useful.
Significantly, regulators in some jurisdictions already employ variants of such tests, and calls have been made to introduce them into the U.S. One such variant is known as ‘reverse stress testing’: financial firms are required to assess scenarios and circumstances that would render their business models unviable, in the process identifying potential business vulnerabilities. Such tests are designed partially to force firms to consider tail risks.
Imposing high hurdle rates in sustainability risk tests would reduce the profitability of unsustainable carbon-related investments that are penalized by such exercises. Incorporating such factors into the stress-testing regime would be analogous to a tax on the funding of planet-damaging activities, addressing the flow of finance toward such projects directly.
(iii) Incorporate climate risks into central bank liquidity frameworks
Central banks – in this case, the ECB – provide funding for commercial banks where required. In doing so, they require the borrowing bank to post collateral – marketable securities – in exchange for central bank reserves. The collateral framework determines the eligibility of financial assets for these facilities, making them extremely potent tools in determining liquidity and portfolio selection at commercial banks. Assets which are eligible for central bank refinancing operations become more attractive for the commercial banking system to hold, which increases demand for them and lowers their yield. Collateral policy, in turn, influences the asset portfolio choices of private commercial banks and other central bank counterparties. Banks prefer to hold assets which are more favourably treated for liquidity and refinancing purposes, which will itself encourage more bank-financed loans and eligible bond issuance by the private sector.
Haircuts (or margin) are applied to collateral on a differential basis: the riskier the asset pledged as collateral, the larger the haircut demanded. There is strong evidence that the parameters applied to assets in collateral frameworks reduce bond yields, reduce interest rates on loans underpinning the relevant assets, and increase credit availability in the asset class concerned. The haircuts applied are then a function of the assets’ features.
Currently, the ECB’s framework does not discriminate between collateral assets based upon the environmental impact of the activities that the relevant assets are financing. This provides no disincentives for lending to unsustainable activities, and the ECB risks capital allocation contributing to environmental damange and climate change. Its framework criteria are based on current credit rating agency analytics, but it could instead adopt existing alternative credit scoring approaches which incorporate risks attached to unsustainable assets; for example, the metrics used by Carbon Analytics, which incorporate transition risk, found that eight issuers would fall out of the ECB’s investment grade criteria and hence no longer be eligible for its monetary policy programmes, representing almost 5 percent of the issuers analysed.
There have been parallel initiatives developed by other central banks, most notably the People’s Bank of China (PBoC), which includes ‘green’ bonds in its collateral frameworks and gives lending priority to banks holding ‘green’ bonds. The PBoC accepts lower-rated ‘green’ bonds for its Medium-Term Lending Facility, through which banks are able to exchange collateral assets for central bank liquidity.
(iv) Credit Guidance
Central banks are afforded extensive supplementary powers to control credit in specific circumstances. Tackling credit growth was traditionally achieved through interest rate policy. However, ultra-loose monetary policies have blunted the effectiveness of the interest rate tool. Moreover, in the case of financial innovations such as securitisation, which increases the spectrum of funding sources, interest rate changes are not as effective on the lending activities of banks which securitise significant proportions of their loans.
Accordingly, many regulatory authorities now rely on various macroprudential policies instead. Many of these tools have been formally developed since the financial crisis, but their historical antecedents are well-established. Most of these policies since the financial crisis have been directed at limiting the build-up of credit in specific sectors, especially the mortgage market. Although the ECB interprets its mandate narrowly, it has tools which could be put to use to limit the credit available for financing unsustainable activities. Importantly, Monnet has shown that policies such as credit allocation through banking supervision, rediscounting, and various types of credit control policies can contribute to state objectives such as industrial policy without damaging growth.
Further, as noted by the United Nations, both maximum credit ceilings and minimum credit floors offer direct and straightforward mechanisms to funnel investments towards particular sustainable projects, while simultaneously reducing the flow of finance to unsustainable assets. Such polices are able to internalize the consequences of sustainability risks, particularly those targeted at controlling credit and sectoral capital buffers targeted at sectors which are particularly vulnerable to environmental or other sustainability factors.
Maximum credit ceilings and other lending restrictions have been put in place across the EU, in particular in terms of higher capital requirements for certain categories of mortgage loans. They have also been employed in other jurisdictions, including China, Brazil and Peru. It is therefore incumbent to ask why, given both the financial stability and social risks inherent in unsustainable activities, the ECB should not use available tools to limit credit for particular projects.
(v) Introduce a Taxonomy of Harmful Activities
The introduction of a taxonomy of harmful activities would assist not only investors but also banks and central banks, allowing to them exclude harmful assets from their portfolios, clients, or bank financing programs. The introduction of such a taxonomy was suggested during earlier phases of the SFI but was abandoned in the face of heavy opposition from financial lobby groups. However, the reintroduction of a taxonomy of harmful activities is essential to make both private and public market actors more sustainable. The TEG, in its March 2020 Final Report, reached the same conclusion, stating that a fully realized taxonomy should incorporate “[t]echnical screening criteria for significant levels of harm to environmental objectives…the so-called ‘polluting’ or ‘brown’ Taxonomy criteria.”
Excluding such activities from any taxonomy will allow companies which undertake them to continue to avoid scrutiny of their portfolios and any potential impact on their financial profile. It will also add to the cost base of companies and product providers that engage in sustainable activity; these costs will not be borne by companies which engage in the most damaging ventures. Finally, a tool of this nature would also enable central bankers and financial regulators to better identify which sectors of activity are most exposed to climate and environmental related financial risks.
Recognising the financial risks of unsustainability is a potential game changer. Ultimately, such financial risk is existential: if we do not manage to find out how to reposition our economies and societies within planetary boundaries, and in a way that secures a safe and just operating space for everybody now and in the future, we risk societal collapse. There are a number of scenarios that can lead to such collapse, including climate change and other environmental degradation, and social unrest caused by the consequences of those phenomena. There are no such social collapse scenarios where investors are likely to receive stable, long-term returns on their investments. This underlines that we cannot settle for a mainstream approach to climate change risks.
In closing, we must also ensure that financial regulation is tailored to tackle all unsustainability risks, no matter their form. Whilst climate change is rightly regarded as cardinally important, we cannot ignore other dimensions of unsustainability. EU regulatory initiatives on sustainability are largely confined to climate change, ignoring the other serious threats to planetary boundaries, such as biodiversity loss. The EU has recently committed to implementing the United Nations Sustainable Development Goals (SDGs), including ensuring its economy is climate neutral by 2050. Yet, the SDGs are not based on an evidence-based understanding of sustainability, which notably should incorporate the planetary boundaries framework. Future iterations of regulatory reform must recognize the dimensions of (un)sustainability which exist beyond climate change.
Jay Cullen is Professor of Law at University of York in UK and an Adjunct Research Professor at the University of Oslo.
Jukka Mahonen is a Professor of Law at the University of Oslo.
Heidi Rapp Nilsen is an Associate Professor in Sustainability and Ethics at the Norwegian University of Science and Technology.
This post is adapted from their paper, “Financing the Transition to Sustainability: SMART Reform Proposals,” available on SSRN.