The ingredients for climate-related capital requirements

This article was authored by Martina Menegat.

Climate-differentiated capital requirements for financial institutions have been proposed as a method for ‘crowding in’ green investment by making it either cheaper to finance climate-friendly activity, or more expensive to finance harmful activity. The debate has been polarised between these two options: a ‘green-supporting’ factor or a ‘brown-penalising’ factor. Yet, things are not always simply green or brown, and the range of policy options is far more varied than this binary choice.

Capital requirements are cushions of capital that banks are required to hold in order to absorb losses, expressed as a percentage of deposits – with a reserve ratio of 20%, banks would need to keep 20% of all their deposits on hand to guard against losses. Adjusting the right amount of capital requirements is a delicate exercise. With a capital ratio fixed at 100%, banks would simply be piggy-banks, able to take in deposits but barred from lending money and investing in the economy. With undercapitalized banks, the risk is insolvency, which triggers expensive recovery interventions. Currently, under the Basel framework, banks  hold a minimum capital ratio of 8% based on their risk-weighted exposures.

The main argument for introducing climate-differentiation capital requirements is that climate change poses relevant, uncosted, risks for the financial system.

Central banks are increasingly committed to identifying, measuring, and assessing climate-related financial risks (CRFRs). The Governor of the Bank of England, Andrew Bailey, believes that stress tests and scenario analysis are the best tools to evaluate CRFRs. Yet, so far they have been incapable to help banks in adjusting their exposures to climate risks.

The main obstacle to accurate pricing of CRFRs is their ‘radical uncertainty’: even if we are pretty sure that a combination of CRFRs will materialise in the next future, there are no advanced methods for calculation. CRFRs are also endogenous to the financial system: the misalignment between the global financial system and Paris climate targets exacerbates the same risks that central banks are trying to measure.

According to Greenpeace UK and WWF UK, UK financial institutions have exposure to high-emitting companies for 1.8 times the country’s domestically produced emissions. Advocates of short-term action argue that patchy data are better than nothing. Hard rules on banks are thought to correct the ‘feedback loop’ between finance and climate, in turn reducing systemic climate risks.

Regulators are showing increasing interest in this topic. While the European Banking Authority is expected to publish its advice to the European Commission on the integration of sustainability in capital requirements by 2023, in the Canadian parliament there is already a proposed law to adjust capital requirements to climate risks generated by exposures to high-emitters.

However, proposals to change banks’ capital requirements have been harshly opposed by the financial industry and so regulators prefer to be cautious. The Bank of England has already examined the possibility to introduce a brown penalising factor, but identified a series of obstacles. Most notably, heightening capital requirements for profitable companies that are conducting brown businesses could destabilise the financial system. Conversely, easing requirements for green companies (the so-called green supporting factor) without accurately calculating their risk profile could create a green bubble.

Climate-related capital requirements need not be reduced to green-supporting or brown-penalising factors. The energy put into the debate is much wider. Academics and civil society organisations have formulated three proposals that are of particular interest.

First, economists have suggested combining a green-supporting and a brown-penalising factors. The simultaneous adoption of such factors will have positive effects on reducing global warming, and thus diminish physical risks for financial institutions. Yet, the same research found that, for example, combining a brown-penalising factor with green fiscal policies will be more apt in addressing financial stability concerns.

Second, other experts argue in favour of a climate systemic risk buffer. A buffer is an additional cushion of a bank’s capital that can be introduced to address exposure to systemic risks. Supervisors can apply a climate buffer on all banks that are particularly vulnerable to CRFR or on all assets that face high risk to be stranded.

Third, a coalition of NGO and CSO organisations has proposed to introduce a one-to-one capital or a 1250% risk weight rule on banks. In this case, banks would be required to hold an amount of capital at least equal to their exposures every time they finance new fossil fuel projects – which are at higher risks of becoming stranded assets in the light of national transition plans.

No single policy is a silver bullet. If introduced, climate-differentiated capital requirements will produce a small contribution to reducing the pace of global warming. It is also unlikely that a slight increase in capital requirements for high-emitter companies will disturb massively the financial system.

Opponents of climate-differentiation capital requirements are right in a sense: they are not the perfect instrument to deal with climate change. However, the perfect instrument simply does not exist. Instead, we have a toolkit of regulatory instruments at our disposal. We need creativity and debate to face the climate crisis.


Why Scotland is the natural home of ethical finance – Chris Tait (The Scotsman)

This article was authored by GEFI Chief Operating Officer Chris Tait, and originally appeared in The Scotsman at https://www.scotsman.com/news/opinion/columnists/why-scotland-is-the-natural-home-of-ethical-finance-chris-tait-3814486

Even with the highest increase for nearly three decades, 1.75 per cent is way below the levels recorded in the late ’90s and the early to mid-noughties.

That’s why, in recent years, many who can afford to do so have turned to investment funds instead.

There is always risk attached to this, and with a recession looming and inflation rampant, it’s vitally important to remember that values can go down further. But the flip side is that you could be buying at a low.

Anyone considering putting money into funds is strongly advised to do so for at least five years, giving more time to ride out the impending bumps in the market.

But another key consideration is how to invest sustainably.

YouGov surveys for the Edinburgh-based Global Ethical Finance Initiative show that Scots consider it important that their investments reflect their views about ethical, environmental, and social issues.

Yet many people who have pensions don’t quite think of themselves as investors, when in fact they are. Others who invest their savings directly in funds perhaps don’t realise the options available to them.

People want financial services companies to take the lead and do more to help.

It’s clear that many people do not yet know how to make responsible investment decisions for themselves, which is why we need to explore awareness-raising and education ideas so that everyone is empowered to take the decisions which reflect their own ethical values.

Next month, the Ethical Finance Global 2022 summit will be held in Edinburgh, which will focus on the role of finance in today’s world, including protecting and restoring nature and biodiversity. With more than half of all Scots indicating the importance of taking ethical, environmental and social issues into account in their investments, Scotland is the natural home of ethical finance.

Edinburgh hosts a large financial sector, and this is something which the institutions must address in the wake of the COP26 climate summit.

Among those attending who will call for greater action are the head of the World Bank and the Bank of England.

Financial institutions undeniably have more to do – and that will be highlighted at the summit – but sustainable investment choices are already becoming increasingly available.

Yet standing in the way of that is a clutter of vague jargon. A fund can be called sustainable, ethical, responsible, green, stewardship, or combinations of these labels and more.

Such labels are used quite inconsistently and two funds with sustainable in their names may mean two different things.

Regulation is trying to help sort this out for the investing public, but time will tell if it will be able to.

Proponents will tell you that sustainable investing will make you more money than alternatives and the critics will tell you it will make less.

As with any investment, returns can vary, but by choosing to invest responsibly you can put your money more in line with your world view and help address the sustainability challenges the world faces.


What does the recent ClientEarth victory mean for finance?

ClientEarth recently won a landmark high-court case in which the Secretary of State for BEIS was ordered to provide more detail on the UK’s plans to achieve net zero. Martina Menegat summarises the background to the case, the decision and what this means for the finance sector below.

Some background:

  • In June 2019, the UK Parliament amended section 1 of the 2008 Climate Change Act to achieve the #netzerotarget in 2050.
  • The Secretary of State was required to break the overall target in a series of 5-year #carbonbudgets leading up to 2052. The budgets were approved by the Parliament.
  • The 2008 Act imposes a legal duty upon the Secretary of State to ensure that the target will be met.

The case:

  • The Secretary of State failed to comply with the Climate Change Act which requires preparing credible policies and proposals to enable the carbon budgets to be met. The policy package published under the Net Zero Strategy is ambitious but too vague: most notably, 1) it does not estimate exactly how policies set out for affected economic sectors will meet the carbon budgets 2) it quantifies how to achieve only 95% of the target of the first carbon budget.
  • As a result, the Secretary of State did not discharge his reporting obligation towards the Parliament – which prevents it from exercising sufficient scrutiny on his activities.

The result:

  • The High Court has ordered the Secretary of State to inform his Strategy with the quantitative effects of sectoral policies. Also, he must explain which policies the Strategy could rely on to meet 100% of its first carbon target. A new report must be submitted to the Parliament and to public scrutiny before the end of March 2023.
  • The Secretary of State was refused the appeal on the basis that has not put grounds with a real prospect of success.

What does it mean for finance?

  • The dilemma that the Secretary of State is called to solve is how to fill the gap between promises and delivery of the Net Zero Strategy. A report published by the House of Lords Industry and Regulators Committee in March already revealed that in the Strategy there was no plan in place to unlock essential investments to lead the #netzerotransition.
  • The Secretary of State will not only have to estimate how to reduce emissions across the economy, but also plan how to pump unpreceded amounts of #greeninvestments into the UK economy.
  • #Followthemoney to test the credibility of the new report. To plan a credible carbon-neutral future, we must have clear in mind how to pay for it. #Climatefinance is ready to meet the challenge.

 Congrats to ClientEarth, Friends of the Earth, Good Law Project and Joe Wheatley for their fantastic work.

 

 

 


Ethical Finance Global 2022 - summit announced

We are delighted to formally announce the launch of Ethical Finance Global 2022, which will take place as an in-person event on 6th September 2022 in Edinburgh hosted by NatWest Group.

The summit is the premier event in ethical finance, and is themed 'ESG in a Volatile World: Profit, Principles or Politics'. It will tackle three core thematics: climate, nature and social. Confirmed speakers include Rt. Hon. Alok Sharma MP, Sarah Breeden, Saker Nusseibeh and Anshula Kant. Click here to find out more.

Our in-person events offer a unique ability to forge connections, and over the years our Summits have built capacity, influenced policy, enabled deals, informed new products, driven framework commitments, helped deploy capital to the SDGs and developed lifelong friendships. If you have attended our flagship global Summit in the past, we would love to see you again in September; if not, then now is your chance!

As well as looking at macroeconomic issues impacting global markets, we will have specific sessions on topics including:

  • The growing impact of conflict and geopolitics in ESG
  • Core global challenges in financing climate adaptation and mitigation
  • The role of finance in protecting and restoring nature and biodiversity
  • The emergence of the S in ESG as a core priority
  • The role of financial leaders in defining organisational purpose
  • Financing the SDGs

Sign up now at https://www.eventbrite.co.uk/e/ethical-finance-global-2022-esg-in-a-volatile-world-registration-349512941617?aff=blog, using the code 'EARLY20' for a 20% early bird discount.


Climate and Ukraine: how to respond to the war by investing in renewable energy

This article was contributed by Martina Menegat.

Red pill or blue pill? Climate or Peace? Since the war in Ukraine has started, we have behaved as though it was possible to choose, but we cannot: we must swallow both pills at once. Energy security and climate security are more deeply intertwined than is generally assumed. A swift transition to renewable energies has the potential to secure a more stable future for the world, at once reducing dependency on regimes accused of rights abuses and decarbonising the energy supply.

The Adaptability Report released by the IPCC in February 2022 found that rising global temperatures have already caused substantial and increasingly irreversible losses across the word. It warns that half of humanity is already at serious risk from climate change, and this risk increases with greater warming. The report was described by UN Secretary General Antonio Guterres as ‘an atlas of human suffering’. The corresponding report on mitigation, published in April, highlights that there are 3 years left to act for keeping alive the goal of limiting warming to 1.5°C .

At the Economist Sustainability Summit, Secretary General Guterres warned that ‘the fallout from Russia’s war in Ukraine risks up ending global food and energy markets, with major implications for the global climate agenda. As major economies pursue an ‘all-of-the-above’ strategy to replace Russian fossil fuels, short-term measures might create long-term fossil fuel dependence and close the window to 1.5°C’.

Russia is the world’s largest exporter of oil, gas and fossil fuels generally, meaning that this war can reshape the world’s energy systems. The EU, a key player in the current geopolitical deadlock, imports around 40 per cent of its natural gas, 25 per cent of its oil and almost 50 per cent of its coal from Russia. However, even if the EU drastically reduces fossil fuel imports from Russia, it should be able to get through the next winter without power outages.

Moreover, the need to bring a rapid end to many nations’ reliance on Russian energy supplies may encourage faster transition to decarbonisation in Europe and beyond, as countries across the world adopt what German finance minister Christian Lindner described as ‘freedom energy’. The case for a phased decline of fossil fuels in the energy mix, however, does not rest on science and geopolitics alone. As the IPCC report on mitigation indicates, renewable energies have never been so affordable. Solar, wind, green hydrogen and batteries enjoy steep and durable learning curves that already make them cheaper than fossil fuels in many sectors and uses.

The same fossil fuels that are funding the conflict are also bringing our planet to multiple tipping points. Currently, we are about to cross 4 out of 10 planetary boundaries, including that of climate change, with others at risk. The biosphere is the fundamental ground on which to build resilient societies and economies. The decisions due to be taken in the coming months represent the last call to accelerate ecological transition.

Focusing back on Ukraine, what can finance do? As the speakers at GEFI’s recent event Responding to the War in Ukraine: Ethical Finance at a time of a crisis emphasised, finance can most effectively support Ukraine by deploying financial resources to accelerate the clean energy transition. This historical moment is well-suited to break the narrative sustained by the fossil fuel industry: that transitions must be long and slow. Deprived fossil fuel profits, amounting to a daily €700 million just from Europe, Russia would lose substantial income to support its military.

To actively support Ukraine, we can act in two ways: as investors, and as consumers. As investors, we must back clean energies, while as consumers, we must change our energy consumption patterns.  Renewable energies are clean, cheap and local, and they have the power to ensure a fairer and more democratic future for all countries.