Climate change: Are markets ready to finance the energy transition?
An overhaul of some economic fundamentals is necessary for finance to really integrate climate change. We are far from it and the clock is ticking
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An overhaul of some economic fundamentals is necessary for finance to really integrate climate change. We are far from it and the clock is ticking
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:
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:
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.
The prudential framework is out of date and will not allow financiers to put a proper price on the financing they are providing to fossil fuel activities.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:
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)
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:
Thierry Philipponnat
Footnotes:
[1] https://www.kempen.com/en/news-and-knowledge/persberichten-2021/carbon-risk-being-underappreciated-by-markets
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