Future of Finance Series, episode 5: Financing the transition to a carbon-neutral economy
The Bank of England’s Future of Finance report emphasises the role finance will play in supporting the transition to a carbon-neutral economy. Encouraging sustainable finance will require recognition of the financial risks of climate change and the mobilisation of private financial resources. Here, we explore the insights on the task at hand offered by the report and the Bank of England’s response.
This is the fifth instalment in our Future of Finance Series, which looks at Huw van Steenis’ Future of Finance Report and the Bank’s response to it.
The transition to a carbon-neutral economy
In 2015, 197 governments formed the Paris Agreement on climate change, committing to keeping global warming well below 2°C and ideally no more than 1.5°C. The FoF report emphasises the huge role finance has to play if this objective is to be achieved. By some estimates, the transition to a low-carbon economy will require investments of more than $90 trillion across the G20 by 2030. The Bank of England (“Bank”) is seeking to encourage an early and orderly transition to a carbon-neutral economy by mobilising the financial sector.
Grappling with the financial risks of climate change
A risk to financial stability
A key point made by the FoF report is that climate change must be understood as a risk to financial stability. It thus falls within the Bank’s remit and is an area where the Bank has already started to take action.
The FoF report follows the widely used approach of breaking the risks down into two areas:
- Physical risks, being the risk of damage to assets from climate and weather-related events, which can cause financial losses, increase insurance claims and impact borrower creditworthiness, for example.
- Transition risks, being the risks posed from the adjustment to a lower-carbon economy - for example, reserves of fossil fuels will become less valuable if they cannot be exploited for policy reasons or due to reduced demand and, if that risk has not been priced in, this could lead to substantial losses.
The FoF report notes that financial markets currently lack understanding of climate change related risks, and this is reflected in the typical relative rates of return on “green” and “brown” assets. Climate change risks do not generally form part of overall financial risk management, and the “tragedy of the horizon” means that long-term impacts are not factored into shorter term decision making.
As part of its moves to safeguard financial stability, the Bank stated in its response to the FoF report that it will conduct climate stress testing for financial institutions in 2021 to help “mainstream” climate risk management. The Bank will publish a discussion paper in autumn of 2019 to facilitate scenario design.
The role and growth of green finance
The report identifies that “green finance” is an important element of financing the transition to a low-carbon economy. It highlights that the demand for green bonds has already accelerated in recent years and that “in some specific cases” green bonds have provided lower borrowing costs than their non-green equivalents. A similar movement is beginning to take off in the loan market, with the rise of green loans and sustainability linked lending. To meet global needs, these trends will need to continue. The report highlights that this presents an opportunity for the UK’s financial sector. That opportunity has also been recognised in the UK Government’s recently published Green Finance Strategy.
Ensuring consistent standards and preventing “green washing"
Importance of adequate disclosures
The FoF report emphasises that a key part of improving awareness of climate risks, as well as mobilising private resources to invest in the transition to a low-carbon economy, is for adequate disclosures to be available. These will provide the information needed to inform investment decisions and risk management.
The Bank itself has been a keen advocate of the Task Force on Climate-related Financial Disclosures (“TCFD”) and its voluntary disclosure regime. Both the FoF Report and the Bank’s response highlight the “virtuous circle” of supply of, and demand for, TCFD disclosures leading to greater adoption and improved disclosures. The Bank in its response to the FoF report commits to continuing to encourage TCFD disclosures, and “expect by 2022 that all listed companies and large asset owners will be disclosing this information”. This is in line with the Government’s expectation in its Green Finance Strategy.
Comparability and enforceability
A key obstacle for green investing is the plethora of different and often non-comparable methods for determining which investments are green. The FoF Report emphasises that loosely constructed and unenforceable standards and definitions can lead to “greenwashing” of “brown” investments, which in turn undermines confidence in green investing.
The FoF Report notes that having harmonised, clear and granular standards for classifying “green” and “brown” activities would assist investors. Industry standards do exist, but are often “high-level, fragmented and voluntary”. Whilst the Bank cannot really put such a framework in place by itself, it is worth noting that the EU is legislating in this area. As part of the EU Sustainable Finance Package, a “Taxonomy” Regulation has been proposed to provide a granular, compulsory and enforceable classification system to determine which investments are sustainable. However, the Regulation is still under negotiation at an EU level as, understandably, creating such a comprehensive and granular framework is both technically difficult and politically contentious.
Next up in our Future of Finance Series and other Sustainable Finance Resources
In the next instalment of our Future of Finance Series we will look at protecting the financial system in response to market changes driven by Fintech and Open Banking. Stay tuned by signing up to our FintechLinks blog.
We recently hosted a webinar on the broader universe of incoming sustainable finance obligations for banks and sell side firms where we discussed some of the Bank’s recent measures. We also discussed how banks and sell side firms may be impacted by client demands. The recording is available here for knowledge portal subscribers.
Please contact the Key Contacts listed or your usual Linklaters contact if you have any questions about sustainable finance.