Climate change: Are markets ready to finance the energy transition?

The role of finance is to allocate capital to the economy at the right price and, for finance to achieve that result, all relevant information must be integrated in the formation of the price at which capital is allocated.

For finance to support fully the energy transition, relevant climate-related information should be integrated in the pricing of financial instruments, whether bonds, shares or bank loans, when capital is allocated to the economy, and in particular to the energy sector.

We are far from it, as the three following situations illustrate:

1 – Informing financial markets, even in the best possible way, will not suffice

Information on the impact of economic activities should be clear, accurate and not misleading.

The EU taxonomy of economic activities is meant to provide such information to financial markets. The Taxonomy has now entered into force for climate-related objectives. This should allow investors to see if an investment has a positive climate impact.

But three points must be made about this Taxonomy:

1. The Taxonomy aims at bringing clarity and rigour to sustainable investment, and it is a welcome objective. The end result will be for funds to provide customers with a percentage of alignment that will indicate how much of their investment has been allocated to sustainable activities.
2. It is a prerequisite to allocating capital to sustainable economic activities, but it cannot be considered as sufficient by itself. Information is indispensable but will not suffice, as being informed is one thing, but having an interest to act is another thing. In other words, let us go all the way to developing as good a Taxonomy as possible, but let us not live under the illusion that, once it is completed, capital will flow massively and exclusively towards sustainable activities and the world will be saved.
3. Gas and nuclear… We saw the proposal of the European Commission, pushed by a number of EU Member States, to include gas and nuclear into the Taxonomy. The problem with this attempt is that it breaks the principle of technological neutrality upon which the Taxonomy is built and that, effectively, it introduces derogations for two sources of energy in a Taxonomy architecture that was carefully crafted over several years of work.
   Notwithstanding the obvious incoherence, this runs the risk of shaking investors’ trust, and this proposal should be rejected as a well-functioning financial system can only be built on trust.

In a nutshell, better sustainability information and a rigorous assessment of criteria as proposed by the EU Taxonomy is indispensable but not sufficient to change the entire game by itself.

2 – Banking and insurance prudential regulations do not reflect the risk linked to fossil fuels  

The prudential framework is out of date and will not allow financiers to put a proper price on the financing they are providing to fossil fuel activities.

The world has today proven reserves of fossil fuels equal to six times its carbon budget. In other words, the world has already six times more reserves than it can afford to extract and burn. This means that any further investment in fossil fuel reserves will be wasted. Money invested will be lost. All financiers know that an investment or a financing at a high risk of being lost should be funded entirely out of equity. This is a basic risk management principle. But today in banking regulation the bulk of fossil fuel exposures command capital requirements comprised between 2% and 4%. The gap is huge with the 100% capital requirement that basic risk management principles (and common sense) would command for new fossil fuel exposures.

This situation has two consequences:

1. Given that a financier’s job is to put a price on a risk, underestimating the risk means underestimating the price. In other words, this under-assessment of risk in prudential regulation acts as an incentive to provide financing at too low a price and therefore develop further what should not be developed further, whether from a world’s sustainability perspective or from a financial stability perspective.
2. By underestimating the risk, we are creating the conditions for a new financial crisis (like the one we had 12 years ago) that will come on top of the looming climate crisis.

This could be avoided by adopting a few simple amendments to the banking prudential regulation (CRR) and the insurance prudential regulation (Solvency II), as detailed in Finance Watch’s publications on the matter. (C.f. links in the box)

3 – We are far from a carbon price up to the challenge

Carbon emissions are what economists call negative externalities. The problem today is that these negative externalities are not priced, or only very partially with the emergence of ‘cap and trade’ mechanisms such as the EU Emissions Trading System.

A most important dimension of this issue is that if companies had to pay for the carbon they emit (i.e. their Scope 1, 2 and 3 CO2 emissions), their profits would be seriously impacted and their value would go down drastically. A recent piece of research by Kempen Capital Management[1] was showing that a price rise of $ 150 per tonne of CO2 would impact stock markets negatively by 41% on average (54% in the US, 31% in Europe…). Clearly the financial system is not ready for this. In any case, this should make us think about the real prospects of the carbon-based economy we are running at the moment. This is also coherent with the fact that, reading the remarkable IPCC reports, we can see that the world economy is headed for a meltdown as it is on a global warming path centred, in all likelihood, around + 4° C by the end of this century. This is what we call ‘disruption risk’ at Finance Watch. And disruption risk is, in our view, even a much bigger risk than climate change-related transition and physical risks.

Conclusion:

The three challenges described here to approach the role of finance in the energy transition rely on a price logic. Resolving those challenges is a pre-condition for the financial system to integrate climate change in a meaningful way, hence the fact that we chose to describe them in the order of likelihood of their resolution:

• Better information / Taxonomy, which is happening now in the EU, and should be supported despite the imperfections and limitations;
• Integration of a proper risk assessment of fossil fuel exposures in prudential regulation: this is highly feasible, provided the political will to do it is there. Interestingly, the momentum is changing on this topic with a growing number of central banks recognising the point. However, this is a legislative matter and legislators throughout the world must now take their responsibilities;
• Integrating carbon price in companies’ accounts. This will be the most difficult part of the task we are facing. However, if we do not do it the world will do it for us, as the current lack of consideration for the most important factor of all leads to a gross overvaluation of financial assets. We may choose to ignore reality, and it can work for some time, but the reality is that today financial assets’ prices do not reflect the inevitable impact of climate change. This is a huge problem, both for the planet and for financial stability, and it will come knocking on our door probably in the not very distant future.

Thierry Philipponnat