Structural changes to the financial system, like innovation in low-carbon financing, could increase climate finance flows.
As COP26 approaches, financial regulators are turning up pressure on the disclosure of climate-related risks. U.N. financial advisor Mark Carney’s COP plan for private finance puts climate transparency at its heart ahead of the U.N. climate summit in Glasgow.
Meanwhile, in the U.S., the Financial Stability Oversight Council has published a long-awaited report on financial climate risk which, as signaled by Treasury Secretary Janet Yellen, takes a cautious approach focusing on the importance of disclosing the financial risks relating to climate change.
The “climate finance disclosure” idea is simple. Companies should measure and publish their exposure to risks of losses if the world moves to quickly address climate change, for example, a bank with loans to thermal coal companies might be exposed to default as cheaper renewables and environmental policies put them out of business. It’s often assumed that this will help the climate: Measuring and reporting these risks will push investors away from dirty assets and increase appetite for green investment.
But in practice, transparency isn’t a silver bullet solution. Understanding what it can’t do tells us what else regulators should be considering, in particular how to restructure financial markets to speed up investment in renewable energy and other climate change solutions.
Despite its rapid growth, the renewable energy sector is still characterized by small participants, often in a single geographic market.
The world’s most valuable commodity, oil, highlights some of the limits of transparency. In both the U.S. and Europe, fossil fuel sector valuations began to decline relative to the broader market well before financial regulators started to consider climate-related risk disclosure in 2015. It’s not climate risk reporting that moves investors, it’s OPEC’s production quotas and relationship with Russia.
The S&P 500 Energy index comprises those companies included in the S&P 500 that are classified as members of the GICS® energy sector, namely Integrated Oil and Gas, Oil & Gas Equipment & Service, Oil & Gas Exploration & Production, Oil & Gas Refining & Marketing, Oil & Gas Storage and Transportation based in the US. The Energy sector is included in the S&P 500 index and accounts for about 2.8% of its composition (Bloomberg 2021).
The MSCI Europe Energy index comprises those companies included in the MSCI Europe that are classified as members of the GICS® energy sector, namely Integrated Oil and Gas, Oil & Gas Equipment & Service, Oil & Gas Exploration & Production, Oil & Gas Refining & Marketing, Oil & Gas Storage and Transportation based in Europe. The Energy sector is included in the MSCI Europe index and accounts for about 4.8% of its composition (Bloomberg 2021).
More transparency won’t help in shifting capital from polluting to greener investments because there is no single “energy investment system” where capital easily moves from one technology towards the other.
Instead, these are two diverse asset classes and should be treated differently. Fossil fuels represent a highly consolidated industry. A few majors –– Chevron and Exxon Mobil –– led market development along with national oil companies like Saudi Aramco and Qatar Petroleum. Meanwhile, the renewable industry remains a young and fragmented sector missing its “majors.” Despite its rapid growth, it’s still characterized by many small participants, often limited to a single geographic market.
That difference in market structure results in lower revenues and market capitalization of renewable players, limiting their ability to attract investment. For the last few decades, fossil fuel assets represented the major target of equity investments in capital markets. They attracted large, stable investments from institutional and investment funds. In contrast, the market for renewable energy companies has low liquidity to attract large funds. The majority of the already-limited renewable assets on the market wouldn’t meet investors’ liquidity criteria because of their small size and daily traded volume.
Structural changes to the financial system, like innovation in low-carbon financing, are more likely to increase climate finance flows.
As far as financial markets are concerned, these assets can’t be substitutes because they have their own unique characteristics and risk factors. No investor will sell a fossil asset and replace it directly with a renewable one. That means better disclosures aren’t likely to facilitate a capital switch.
Instead of ever more disclosure, structural changes to the financial system, like innovation in low-carbon financing, are more likely to increase climate finance flows.
First, the financial ecosystem needs to expand to bring low-carbon investing into the mainstream, making it more attractive to investors. This means scaling up existing green financing channels like green bonds and exchange-traded funds (ETFs), and further securitization of alternative energy assets that appeal to broader financial market participants. Climate and energy policies need to play their part by incorporating financing considerations, like investor preferences, risk appetites and capital base, into policy design to create a stronger ecosystem for green assets.
Second, green policies need to be better integrated into monetary, fiscal and macro-prudential policy. Introducing climate considerations into monetary policy would directly impact central banks’ asset purchases. This is particularly relevant considering that most Central Banks’ corporate asset purchases remain biased towards high-carbon industries. Another option already under consideration by the European Parliament and Commission is introducing a green supporting factor to bank capital reserve requirements. It would incentivize green investing by lowering the risk weights applied to low-carbon loans and investments, reducing banks’ capital ratios for these assets and increasing their overall leverage.
Third, international climate policy should prioritize capital flows in developing countries. This is a critical challenge facing international climate cooperation given the difficulties that these countries have in accessing capital at favorable terms. International action needs to create financing channels to attract diverse private capital, reduce costs and create sustainable international financial structures.
Expectations about the impact of transparency are running high, fuelled by regulators pinning their hopes on disclosures. That risks exempting the finance sector from the need for more radical action that leads to long-term systemic changes. Disclosure initiatives may eventually help to preserve financial stability from climate risks, but they don’t help us stabilize the climate.