Our selection of recent analysis on sustainable finance and climate risk

According to a recent study, 2021 is expected to be the first year on record that sees CO2 levels of more than 50% above pre-industrial levels for longer than a few days (around 417ppm, a 50% increase since the 18th century average). In the meantime, the most recent overview of climate finance published by the Institute for Climate Economics (available here) shows that despite their recent growth, climate investments remain insufficient in relation to the needs. This deficit can be explained, among other things, by the lack of profitability of projects, regulatory obstacles, or the lack of adequate financing. To make up for the delay on the trajectory of the French national low-carbon strategy, 13 to 17 billion € more than in 2019 would have to be invested each year in the building, transport and energy sectors, in France only.

A recent Financial Times article, entitled “How to take the long-term view in a short-term world”, underlines that surging inflows into sustainable funds boost the financial case for long-termism (i.e. mid-March French new green sovereign bond issuance), though a multitude of external factors still promote short-termism (earning pressure from investor, competitive pressure, economic uncertainty, limited access to capital, customer demands, limited board diversity…). The article still highlights: “the conversation starts to shift […] with the financial case looking clearer, this is a moment for companies and investors to move past the finger-pointing and to support each other in making long-term approaches the default rather than the exception”.

Here is a selection of literature by Policy Shift while we approach the end of March 2021.

Biodiversity under the financial spotlight

A symptomatic announcement: BlackRock recently warned companies that rely on nature or have an impact on natural habitats to publish a “no deforestation” policy and their strategy on biodiversity or face pushback from the asset manager at their annual meetings.

The Dasgupta Review on the Economics of Biodiversity published last February provides a comprehensive economic overview of the valuation of ecosystems, but also of the loss of capital that has occurred over the last 30 years, and the impact on individuals and economies. For example, the report points out, based on a study by Managi and Kumar (2018), that while since the early 1990s, global produced capital per capita has doubled and human capital per capita has increased by about 13 percent, the value of the natural capital stock per capita has declined by nearly 40 percent.

A handbook published on March 1st by the Cambridge Institute for Sustainability Leadership encourages financial institutions to begin embedding nature into mainstream financial models, risk frameworks and portfolio strategies, notably by providing a framework for identifying nature-related financial risks.

In the same vein, the UN Principles for Responsible Investment have published a discussion paper on investor action on biodiversity (available here), which describes possible actions: awareness and commitments, stewardship, policy (EU Taxonomy, investor disclosure…), and other meaningful data.

The paper recommends that investors should :

• allocate capital to sectors or business models which are avoiding and reducing biodiversity loss and increase opportunities for positive outcomes on the ground;

• engage investees on reducing negative biodiversity outcomes and design stewardship approaches to deliver positive biodiversity outcomes;

• engage policy makers on reforming incentives, including subsidies, to activities that drive biodiversity loss;

• build internal capacity to ensure awareness of biodiversity’s importance;

• test new tools and measurement approaches to understand how investments shape biodiversity outcomes;

• engage with companies and data service providers to provide meaningful, consistent data;

• engage with green funds, bonds, commodities and certification schemes to integrate biodiversity into existing standards; and

• collaborate with peers and stakeholders to enhance nature-related financial disclosures.

Across the pond: recapturing U.S leadership on climate and sustainable finance

While the CEPII has published an interesting brief about the recent alignment of the EU and the US on climate (see here, in French), the U.S Environmental Defense Fund, an NGO dedicated to environmental protection, published on March 2, 2021 a report entitled “Recapturing U.S Leadership on Climate: Setting an Ambitious and Credible Nationally Determined Contribution”, that demonstrates how a 50% greenhouse gas emissions reduction is achievable in the U.S through multiple policy pathways (including new legislation limiting emissions for the power sector, vehicle standards, methane standards (Appendix C is particularly enlightening), advances in climate-smart agriculture and forestry). It insists a whole-of-government approach is needed: “An enforceable declining limit on emissions and a price on carbon can supercharge action across the economy, allowing us to get there faster and more affordably, and ensure we hit our climate goals”.

On the front of financial regulation, worth noting are two recent streams of progress:

1. The U.S. Department of Labor has announced that it will not enforce recently published final rules on “Financial Factors in Selecting Plan Investments” and “Fiduciary Duties Regarding Proxy Voting and Shareholder Rights”, proposed under the former administration and heavily criticized;

1. The U.S Securities and Exchange Commission has published a dedicated statement on ESG disclosures, showing that the SEC wants to promote mandatory and voluntary ESG disclosure, as well as an international framework under the IFRS Foundation (see consultation here).

In the context of the Biden’s Infrastructure plan being unfolded (see this Bloomberg article), this report by the ClimateWorks Foundation, published on March 16th, 2021 and entitled “Decarbonizing concrete: deep decarbonization pathways for the cement and concrete cycle in the United States, India and China” illustrates the pathways that can get such industries to net-zero emissions by 2050. Several levers of decarbonization are described, including conventional approaches (kiln efficiency, use of biofuels…) and emerging technologies (cement chemistries, materials efficiency, carbon capture and utilization).

Recent literature on climate risk: a focus on IMF surveillance and climate change valuation adjustment

Worth reading is the climate science-based sovereign credit rating report, recently published by the Bennett Institute for Climate Policy of the University of Cambridge. Its innovative approach lies in the use of IA to simulate the effects of climate change on Standard and Poor's credit ratings for over 100 countries over the next 10, 30 and 50 years and by 2100. The report finds strong evidence that stringent climate policy, consistent with a 2°C pathway, would nearly eliminate the effect of climate change on ratings. This report echoes the European Central Bank's preliminary findings of its economy-wide climate stress-test, showing that under the ‘hot house world’ scenario, which assumes no climate policies are taken, the chaos unleashed by more frequent and damaging natural disasters incurs losses on companies that exceed the costs of moving to a low-carbon economy under both the ‘orderly’ and ‘disorderly’ transition scenarios.

A policy brief published by the Global Development Policy Center of Boston University (Gallagher K., Ramos L., Stephenson-Johnson C. and Monasterolo I.) in March 2021, deals with the International Monetary Fund’s climate ambition in its surveillance activity, a few months after the IMF pledged to incorporate climate change in its current reviews of the Article IV (i.e. assessment of a country’s economic and financial development) and Financial Sector Assessment Programs (Adrian et al. 2020). Such evolution is indeed key in order to consider climate-related financial risks. Yet, the policy brief shows that published Article IV and FSAP reports since 2017, while discussing climate change in some detail, do not yet conduct market surveillance with regard to climate change related risks, including spillover risks.

A technical – but very insightful – research paper on climate change valuation adjustment was published at the end of February by C. Kenyon C. and M. Berrahoui. It builds on the fact that in view of climate change risk, credit valuation adjustment quantifies expected loss on counterparty default and the costs of funding are captured in funding valuation adjustment. However, such methods are based on extrapolation of credit default swap spreads (which are typically traded only up to 10 year maturity) and inclusion of bond trading – which cannot take full account of climate-related risks. The authors therefore introduce in their paper a “climate change valuation adjustment” to capture the difference in expected loss and funding between usual credit information extrapolation and the parameterized inclusion of economic stress from climate change endpoints and transition effects. Client transactions, especially project finance for essential infrastructure, indeed can go out 30 years or more so credit valuation adjustment requires extrapolation of CDS spreads beyond 10 years. Climate change may impact counterparty default on these timescales. Climate change valuation adjustment could be negative in cases where climate change has favorable outcomes (e.g. lower cost). Therefore, the paper introduces this “climate change valuation adjustment” to capture climate change impacts on credit and funding valuation adjustment (currently invisible assuming typical market practice); as well as a direct, flexible, and expressive parametrization to capture the path of instantaneous hazard rates to climate change endpoints.

On the central banking side, two papers worth pointing out:

• A report entitled “Net-zero central banking: a new phase in greening the financial system”, published by the Grantham Research Institute on Climate Change and the Environment on March 15, 2021, which addresses a set of seven recommendations for central banks and supervisors to adjust current approaches and measures in line with net-zero.

• A report entitled “Greening the Eurosystem collateral framework how to decarbonize the ECB’s monetary policy”, published by Dafermos and al. in March 2021, comes back to the debate on the Eurosystem collateral framework and its impact on the financing of carbon-intensive companies. The report shows that it has a carbon bias, favoring fossil fuel companies disproportionately to their contribution to EU employment and the direct production of goods and services. Overall, carbon-intensive companies issue 59% of the corporate bonds that the ECB accepts as collateral, while their overall contribution to EU employment and gross value added is less than 24% and 29%, respectively. According to the paper, the ECB's collateral framework implicitly encourages fossil fuel companies to increasingly tap bond markets − for example, showing that four large (mostly gas) fossil fuel companies rely on bonds subsidized by the ECB collateral framework for more than half of overall financing;

• A speech by Isabel Schnabel, member of the Executive Board of the ECB, delivered at the beginning of March, entitled “From green neglect to green dominance”, on greening of monetary policy. A key fundamental excerpts:

“While it is widely acknowledged that governments and regulators bear the primary responsibility for designing and implementing environmental policies, there is by now a widely shared understanding that central banks cannot stand on the sidelines. My fellow ECB Executive Board member Frank Elderson recently argued convincingly that the ECB is not only allowed, but required, by the Treaties to take climate change into account in its actions.

[…] So the question is not whether the ECB should incorporate climate change and other aspects of environmental protection into its monetary policy decisions, but how and to what degree this should be done.

[…] However, this interpretation of the principle of market neutrality is increasingly challenged on the ground that it may reinforce market failures that decelerate society’s transition to a carbon-neutral economy and may therefore impede, rather than favor, an efficient allocation of resources. More generally, one may question whether the market is the appropriate benchmark in the presence of environmental externalities.

[…] One possible avenue for action is to incorporate sustainability criteria into the implementation of our private sector asset purchases. In light of the observed emission bias in our corporate bond portfolio, we need to carefully re-assess the current notion of market neutrality. In its current interpretation, it appears to hamper an efficient allocation of resources as it does not reflect the significant externalities that climate change exerts on society

[…] At the same time, it has to be acknowledged that central bank policy cannot, and must not, replace government policies. Monetary policy actions vary over the business cycle, while the effective mitigation of climate change requires permanent and structural measures, which only governments can provide”.

Beyond green bonds

Two reports that Policy Shift strongly recommends in the bustling green bond context:

• This article by Gianfranco Gianfrate and Marco Spinelli, “Do the shades of green matter? The pricing and ownership of “dark green” bonds” (January 2021), investigates the pricing of the bonds with the highest climate impact rating, in a context where the empirical evidence about the existence and magnitude of a green premium (or “greenium”) is far from unanimous (MacAskill et al., 2021). It finds that, on average, so-called “dark green” bonds are not priced differently from similar non-green or “light green” bonds. The article underlines that the ownership of dark green bonds significantly differs from that of other bonds, in that institutional investors committed to integrate sustainability in their investments have significantly higher stakes in dark-green bonds. Therefore, the article concludes that while markets do not seem to price dark-green bonds differently from conventional bonds, they are able to importantly attract climate aware investors;

• This report by the Observatoire de la RSE (French CSR Observatory), published in March 2021, draws up a welcome overview of existing sustainable bonds, illustrating their diversity (green bonds, cat bonds, transition bonds, blue bonds, rhino impact bonds, sukuk bonds, social bonds, SDG-bond and sustainability-linked bonds) but also their advantages and limits in the current market and regulatory context.

And as a bonus reading:

• This article by M. Migliorelli, very much welcome in a context of expansion of sustainable finance, entitled: “What do we mean by sustainable finance? Assessing existing frameworks and policy risks” (published in January 2021).

• This article by N. Arriba-Sellier, entitled “Turning Gold into Green: Green Finance and the mandate of European Financial Supervision” (published in February 2021), providing an insightful legal analysis on the European Supervisory Authorities’ “green” mandates and powers:

“Yet, the EU response has so far focused on transparency, rather than on financial risks. Investor protection, rather than financial stability. Financial regulation, rather than financial supervision. The amendments to the ESAs Regulations and banking regulation have been modest, especially in comparison of the sweeping new transparency regulations, like the Sustainability Disclosures Regulation and the Taxonomy Regulation. It remains a long way for the European Union and its supervisory authorities to take the measure of climate change and its related risks”.