Weekly News: our selection of recent analysis on climate risk and sustainable finance

Every week, Policy Shift will share a selection of recent articles and publications focused on public policy and innovation. This week's theme deals climate risk, but also proposals and evolutions in the sustainable finance field and in climate change economic policy.

An academic paper (in English) about the challenges associated with “green” fixed-income securities

By Kim Schumacher, this paper aims at illustrating the need for further structuring and clarifications in the area of green bonds. Fixed-income securities that use their proceeds towards the financing of ESG-aligned projects (throughout the entire investment chain) have indeed proved particularly attractive among investors (check out the PRI’s guide to fixed-income sustainable investing here), especially since their inception by the European Investment Bank (the “Climate Awareness Bonds”) and, later, the International Finance Corporation, respectively in 2007 and 2010. Research has shown that green bonds often have higher yields, lower variance, and are more liquid, if compared with theory closest brown bond neighbors (Bachelet et al., 2019). Some issuers have also been advocating for a “greenium” that investors should pay and would cover the additional cost associated with pre-issuance third-party and post-issuance impact monitoring and reporting (Weber and Saravade, 2019). Still, Gianfrate and Peri (2019) observed that green bonds are actually more convenient than conventional bonds because the magnitude of the savings for issuers (in terms of interests paid) exceeds the costs of getting third-party certification or verification.

However, it has become particularly challenging to fully untangle the increasingly complex language and principles found across the green bond spectrum. A notable example lays in the difference of rules and frameworks pertaining to domestic green securities in China, with those laid down by international. For instance, Chinese green bond guidelines used not to exclude investments in “ultra-super-critical” coal-fired power generation – an approach that stood in stark contrast with the predominant international standards (CBI Standards and International Capital Markets Association’s Green Bond Principles). This situation sometimes required trading platforms to make adjustments in order to take account of these “taxonomical” divergences. However, in an imminent policy reversal, a draft for consultation of the 2020 edition of the People’s Bank of China’s Green Bond Endorsed Projects Catalogue dropped fossil fuel-related projects, including coal, from its taxonomy of eligible green projects.

With an inflation in green bond labels and designations, several products have often been denounced as greenwashing attempts, such as a sustainability-linked bond by Italian energy conglomerate Enel - though some researchers underlined that Enel’s bond in question presented more comprehensive target-setting and incentives to reach the latter than conventional green bonds up to that moment (Dupré, 2019). While no proper standards have been fixed for the green bond market, new regulatory proposals such as the EU Taxonomy and the forthcoming EU Green Bond Standard, have emerged, aiming at creating uniform frameworks and standards that will reduce greenwashing, increase transparency, and comparability of ex-ante project-related impact assessments and ex-post impact-related data collection. Post issuance reporting is particularly important in measuring the veritable impacts of projects financed by green bond funds. Bridging the informational gap between issuers and investors is indeed seen as probably the most important challenge for green bonds at the moment.

This paper related to the ongoing EU Green Bond Standard consultation, but also to existing discussions on the “transitional” nature of the EU Taxonomy, providing decarbonation pathways for transition and transition-enabling economic activities. Furthermore, it is incontestably related to the debate on whether a carbon-intensive company “can” issue a green/transition bond.

Worth noting that the European Central Bank has announced it will from next year accept as collateral green bonds with payout directly linked to sustainability targets, and also include such debt in its asset purchase schemes. It marks the first tangible step towards making the ECB’s monetary policy “greener”.

An academic paper (in English) about the economic impact of shock to transition risk

By Christoph Meinerding, Yves Schüler and Philipp Zhang, this paper is a contribution to the literature on transition (climate-related) risk, which has received much less attention (than physical risk), given to the absence of a proper definition of transition risk (i.e. the risk result from the process of adjustment towards a low-carbon economy) and the larger challenge that represents the measurement of such risk (i.e. expected path or distribution of paths toward a low-carbon economy; endogenous factors affecting such paths; relation of proxies to this path).

The paper proposes a method to measure transition risk by detecting instances at which a significant piece of new information about the distribution of possible transition paths is revealed. Therefore, for an event to qualify as a shock leading to transition risk, it must impact the valuation of “green” and “brown” firms differently while relating to economic news on climate change (e.g. a negative shock is an event decreasing the likelihood of a fast and orderly transition).

The paper then analyzes their economic impact within a macro-financial Bayesian VAR framework, finding significant shocks reducing industrial production and processes; deteriorating credit conditions and inducing uncertainty in climate-sensitive industries (e.g. oil and gas). It also detects asymmetries between positive and negative shocks to transition risk (i.e. increases in transition risk are more persistent, while negative shocks to transition risk are perceived as rather short-lived), suggesting a broad belief that the economy will eventually adjust to lower carbon emission standards.

An academic paper (in English) about “climate sentiments”, as financial actors’ perception of climate-related financial risks and their anticipation in risk management strategies

By Irene Monasterolo, Natalie Glas and Sabine Kunesch, this paper aims at showing that climate-related financial risk understanding and perception are largely heterogeneous across financial actors in portfolios’ risk management practices – mainly due to lack of stable climate policies and regulations, of standardized sustainability scores of financial contracts and of financial risk pricing tools. In a context where 260bn€ of additional annual investments in renewable energy, energy efficiency and low-carbon transport are needed in the EU to achieve current EU 2030 climate and energy targets, the decline of the contribution of fossil fuels to the gross value added in not declining at the pace needed in most economies. Therefore, in the financial sector, investors are exposed to activities and assets that are likely to lose value in a disorderly low-carbon transition and financial markets are not yet pricing in climate risks (Battiston and Monasterolo, 2020; Battiston et al. 2017; Leaton et al. 2012). Current plans of expanding fossil fuel production will indeed lead to emission levels in 2030 that are about 50% higher than those consistent with (median) cost-effective 2°C mitigation pathways: this is why the current delay in implementing ambitious policies may lead to stronger future interventions, increasing the cost of climate policy due to sunk investments in the fossil sector (Edenhofer et al., 2020; Jakob et al., 2012; Kriegler et al., 2018).

The role of investors’ sentiments has been studied in the literature mainly in the context of credit cycles (Greenwood & Shleifer, 2014), and it has been extended to consider their perception of climate physical and transition risk (Dunz et al., 2020) – though it is still at an infant stage. In this paper, researchers have put forward three research questions: (i) are financial actors considering, and to what extent, climate change in financial valuation; (ii) do divestment and engagement actions influence the market benchmark; and (iii) what are the perceived barriers and opportunities to embed climate risks in business models and financial valuation?

On the basis of the abovementioned questions submitted during several workshops and following an interdisciplinary approach, researchers concluded:

“Main barriers to mainstream climate financial risk assessment in financial actors’ business are recognized in the lack of stable and coherent climate policies and regulations, in the poor comparability and transparency of sustainable financial products (e.g. the ESG investments) and lack of an operative taxonomy of green (and brown) investments, in poor knowledge and missing incentives. In contrast, improving carbon footprint, access to historical and quality data, and availability of science-based metrics and methods, speeding up climate risk awareness and building capacity within the financial sector represent opportunities to align finance to sustainability and mitigate the risk of stranded assets.

Interestingly, financial actors showed a limited understanding of the difference between the long-term nature of climate risk and the short termism in financial decisions, and of fat tailed risk in scenarios. In addition, they underestimation of the challenges of the development of the green financial market and for assessing climate-related financial risks”.

An academic paper (in English) about the role of green credit policy to foster the transition and preserve price and financial stability

By Francesca Diluiso et al., this paper aims at providing a comprehensive analysis of the role of central banks in addressing transition risk toward a greener economy, under different policy scenarios (comparison of a linearly-increasing carbon tax with an exponentially-increasing carbon tax; evaluation of the potential effects of brown-penalizing/green-supporting financial regulation; analysis of the transmission into the economy of an asset price shock in the fossil sector). It addresses the three following questions: to what extent and under which conditions is climate policy a source of macroeconomic and financial instability? How and when can central banks use green financial regulation and green credit policy to foster the transition and preserve price and financial stability? And, finally, are green financial regulation and green credit policy in conflict with central banks’ mandates?

The concerns around the alleged “carbon bubble” and stranded assets have indeed penetrated into policy circles and kicked off a debate on transition risk, and on macroeconomic and financial stability. Among others, this has also caught the attention of a growing number of central banks around the world. It is now widely accepted that transition risk poses a new threat to financial stability. Previous academic research discussed the role of central banks in the transition, by proposing several new green financial and monetary tools tailored to limit systemic risk and redirecting resources toward low-carbon sectors (Campiglio et al., 2018; Dafermos et al., 2018; D’Orazio and Popoyan, 2019): however, modeling attempts to study the impact of these green policies are still at an early stage.

The paper concludes that:

- A mitigation strategy based on a credible carbon price does not undermine financial stability, and transition risks seem to be limited in the scenario of a progressive evolution of a carbon price allowing markets to anticipate the effects of the mitigation plan and distribute the transition costs;

- Green credit policy implemented in response to a financial crisis in the fossil sector stabilizes financial markets and sustains the aggregate demand. It should only be considered as a tool to react to financial instability that may emerge during the transition, but they should not be invoked as a standalone mitigation instrument to reshape the economy in normal times;

- The violation of the principle of neutrality in conducting credit policy may create excessive imbalances in the exposure of intermediaries’ portfolios and be a source of undesirable consequences. There is however room for new green instruments, which, should be designed carefully, balancing all the trade-offs in place.

A policy report (in English) about U.S financial regulatory policy and climate-related financial risks

By the CFTC, this report is one-of-a-kind amongst financial regulators in the United States. Structured into 8 chapters, it is the first ever report to address physical and transition risks in the context of the U.S and their implications for the U.S financial system; as well as climate risk management practices, climate scenarios, climate risk disclosure and ways of financing the net-zero transition.

The central findings of the report are:

- Climate change is likely to pose systemic risks to the U.S. financial system, especially given that financial assets do not fully reflect climate-related physical and transition risks. A sudden revision of market perceptions about climate risk could lead to a disorderly repricing of assets, which could in turn have cascading effects on portfolios and balance sheets and therefore systemic implications for financial stability;

- Regulators should be concerned about the risk of climate-related “sub-systemic” shocks (i.e. those that affect financial markets or institutions in a particular sector, asset class, or region of the country, but without threatening the stability of the financial system as a whole), that are particularly relevant considering the size, magnitude and high degree of fragmentation of the U.S financial system. These types of shocks can undermine the financial health of community banks, agricultural banks, or local insurance markets, leaving small businesses, farmers, and households without access to critical financial services.

- While existing legislation already provides U.S. financial regulators with wide-ranging and flexible authorities that could be used to start addressing financial climate-related risk now (i.e. oversight of systemic financial risk; risk management of particular markets and financial institutions; disclosure and investor protection; safeguarding of financial sector utilities), these authorities and tools are not being fully utilized to effectively monitor and manage climate risk. A coordinated national response is needed;

- The lack of common definitions and standards for climate-related data and financial products is hindering the ability of market participants and regulators to monitor and manage climate risk. While climate-related scenario analysis can be a useful tool to enable regulators and market participants to understand and manage climate-related risks, they have several limitations (sensitivity to key assumptions and parameters; full awareness of what it can and cannot do);

- The existing disclosure regime is still behind and has not resulted in disclosures of a scope, breadth, and quality to be sufficiently useful to market participants and regulators. Several barriers need to be overcome: the misperception that sustainable investments necessarily involve trading off financial returns relative to traditional investment strategies; the lack of trust in the market over concerns of potential “greenwashing”; policy uncertainty…

- Derivatives markets can be part of the solution, as commodity derivatives exchanges could address climate and sustainability issues by incorporating sustainability elements into existing contracts and by developing new derivatives contracts to hedge climate-related risks. Development of new derivatives will require that the relevant climate-related data is transparent, reliable, and trusted by market participants.

The report recommends notably that:

- U.S financial regulatory agencies – as well as the Financial Stability Oversight Council - incorporate climate-related risks into their mandates, existing monitoring and oversight functions, as well as balance sheet management and asset purchases. They should undertake pilot climate risk stress testing;

- U.S regulators join existing international fora on these issues (NGFS, Coalition of Finance Ministers for Climate Action, Sustainable Insurance Forum) and engage actively to put climate risk on the agenda of G7 and G20 meetings (including the FSB);

- Climate risk monitoring and management should be embedded into firms’ governance frameworks, and material climate risks must be disclosed under existing law (with an update of the SEC’s 2010 guidance on climate risk disclosure), at least for scope 1 and 2 greenhouse gas emissions;

- Financial regulators should support the availability of consistent, comparable and reliable climate risk data and analysis, as well as standardized and consistent classifications or taxonomies for climate-related financial risks (exposure, sensitivity, vulnerability, adaptation, resilience) spanning asset classes and sectors. They should establish climate finance labs and regulatory sandboxes to enhance the development of innovative climate risk tools and financial products.

An academic paper (in English) about the financial impact of fossil fuel divestment

While the fossil fuel divestment movement heralds divestment from fossil fuel producers as a means to combat climate change, financial investors also want to be assured of sufficient returns and limited risks to support the living costs of their ultimate beneficiaries. In this context, the paper by Auke Plantinga & Bert Scholtens aims at investigating the impact of divestment and the transition of the energy system on investment performance, relying on an international sample of almost seven thousand companies on a period of forty years.

The methodology is the following:

- Analysis of returns of investment by industry, taking into account the structuring of portfolios by industry and its role in asset allocation;

- Creation of an "industry index" derived from the ICB classification, with adjustments, corresponding to a "fossil fuels index" including O&G producers, O&G services and equipment and the coal mining industry (327 companies). A "non-fossil fuel index" is also created, composed of 6500+ companies. The approach is to track production (not consumption of fossil fuels by companies and households);

- Explanation of the ROI of financial assets according to Fama and French’s 5-factor pricing model (2015) and use of the Sharpe ratio as a measure of profitability ;

- Analysis of three investment strategies: (i) the 'conservative' investor strategy (i.e. excluding fossil companies from the investment universe); (ii) the institutional investor/passive management strategy (market capitalization weighting); and (iii) the individual investor strategy (i.e. equal weighting by industry).

The paper investigates scenarios with very different pathways to the transition of the energy system, and find that the investment performance of portfolios that exclude fossil fuel production companies does not significantly differ in terms of risk and return from unrestricted portfolios (such finding holds even under market conditions that would benefit the fossil fuel industry). The paper concludes that divesting from fossil fuel production does not result in financial harm to investors, even when fossil fuels continue to play a dominant role in the energy mix for some time: it is therefore not at odds with the fiduciary duty of institutional investors and paves the way for more extensive initiatives to promote fossil fuel divestment. The paper eventually underlines that a smooth energy transition will most likely erode the profitability of fossil fuel firms and their ability to invest – suggesting that governments cannot rely on the fossil fuel industry to finance the energy transition.

The International Finance Corporation (the World Bank’s private sector arm) has introduced new climate change conditions for its investments in commercial banks to encourage lenders to wind down support for coal projects in Asia and in Africa – hoping that it will trigger other investors to exit the coal sector.

A technical document (in English) about the mainstream of environmental risk analysis in the financial sector

By the Central Banks and Supervisors’ Network for Greening the Financial System (NGFS), the document insists that in order to effectively address climate-related and environmental risks, greater collective efforts are urgently needed from regulators, financial institutions, international organizations, third-party vendors, and academic institutions to promote the wider adoption of environmental risks analysis in the financial industry. It specifies opportunities for mainstreaming environmental risks analysis:

- Enhancing environmental risks analysis awareness among financial institutions by central banks and supervisors conducting environmental risks analysis themselves and clarifying expectations or standards for financial institutions to implement it;

- Reinforcing capacity building and supporting demonstration environmental risks analysis projects in key sectors such as banking, insurance and asset management, and for key regions exposed to substantial environmental and climate-related risks;

- Disclosing risk exposures and environmental risks analysis results according to a consistent climate and environmental disclosure framework; and

- Developing key risk indicators and statistic to facilitate the identification, measurement and data comparability of environment- and climate-related risks.

An article (in English) about the linkage between international trade networks, the Covid-19 crisis and climate

By Andreas Goldthau and Llewelyn Hughes in the Nature review, this article underlines that the Covid-19 crisis has got a harmful impact on global supply chains, with worrying effects on low-carbon energy (“closed borders, silent factories and shortages of components are slowing the deployment of wind turbines, solar panels and electric vehicles worldwide, with little time left to avert dangerous climate change”). As a result, this year’s growth in renewable electricity capacity is expected to fall short of last year’s figure by 13%, owing to supply-chain and financing problems, but also manufacturing reshoring policies. However, the authors underline that networks of cross-border trade and investment keep costs down and encourage learning and innovation (“without global supply chains, technological progress will slow and cost reductions stall”), giving the example of China’s domination in solar photovoltaics.

Building on a fierce criticism of “reshoring”, the authors therefore encourage governments to put in place sustainable industrial strategies that focus on developing innovations and bringing them to market (with regulation, investment and subsidies), rather than replacing established supply chains for mature technologies. It is also to them a matter of geopolitical risk exposure (“owning a key component, or ‘node’, in a supply chain gives a company or nation leverage over the entire network. Taken to the extreme, this asymmetry can be ‘weaponized” […] Playing geo-economics with supply chains, by contrast, will result in fragmented markets, higher costs, lower efficiency and loss of jobs on US soil and elsewhere”).

An article (in French) about the necessity to adopt a “trajectory” approach in climate change adaptation

By A. Magnan, A. Anisimov and V. Dépoues, this article builds on the recent IPCC special reports that underline that some of climate change-related impacts are already inevitable, especially regarding the ocean, the cryosphere and land. Combined with the effects of non-climatic pressures on the environment (pollution of coastal waters, overexploitation of resources, urban pressure), these consequences explain why many species and ecosystems will have to face high levels of impact, even in the case of global atmospheric warming limited to +2°C by 2100.

In this context, the article stresses that adaptation to climate change is both a present emergency and a long-term requirement. It calls for a review of the way contemporary societies will reconsider their relationship to environmental risks, the finiteness of natural resources and consumption, and consequently to current development models as a whole. The Covid-19 has nonetheless shown that temporalities that were thought to be unsustainable a short time ago, for example in terms of radical political decisions or constraints imposed on lifestyles, may not be so much so, and that depending on the urgency attributed to a problem, initiating a profound transformation now is within our societies’ reach.

Given that the changes taking place in the ocean (warming and acidification) can turn actual solutions obsolete in a short to medium term, the authors point out the need for a "trajectory" approach to be adopted, in order to organize the sequencing of solutions over the long term and not to take isolated actions. Such solutions include "heavy defense" of shorelines (dikes to protect against waves, riprap to prevent coastal erosion, etc.), where population densities are high and environments are already highly degraded. They also include "strategic withdrawal" aiming at relocating people, goods and activities to areas that are less at risk (e.g. one of the strong pillars of the coastal risk management strategy in New Aquitaine in France). However, the authors underline that such implementation presupposes a profound social and economic dialogue. It also requires governments to “juggle” with time scales and with uncertainty, and asks the following questions: “what does it mean, for our territory, to be "adapted"? What risks are collectively "acceptable”? What are the thresholds that are supposed to trigger the switch from one option to another, on the potential barriers that need to be removed upstream to allow this switch to take place at the right time?”.

An article (in English) about the co-evolution of technological promises, modelling, policies and climate change targets

By Duncan McLaren and Nils Markusson in the Nature review, this article, by taking stock of the succession of climate targets and mitigation approaches since 1990, describes how, over the past 30 years, the way in which climate change targets are described has constantly evolved (from percentages of emission reductions, to atmospheric CO2 concentrations, carbon budgets and, nowadays, temperature limits). The article points out that these changes do not only reflect advances in climatology, but have also paved the way for various technological approaches that have failed to deliver on their promises, delaying change rather than accelerating it. The past three decades are divided into five successive phases of international negotiations, each being characterized by a particular way of defining climate change mitigation targets, as well as a set of proposed measures.

The authors’ analysis shows how deception around international climate negotiations has emerged from the coevolution of technological promises, modelling techniques and political aspirations, especially around the framing of targets. Based on their findings, the authors stress that adding new technologies can bring the climate challenge under control, only if it associated with behavioral, cultural and economic transformations. However, they also underline: “technological promises allow those benefiting from the continued exploitation of fossil fuels and the comfortable lifestyles it enables to justify those practices to themselves”.

A report (in French) about the economic policy response to the biodiversity collapse

By the French Council on Economic Analysis (Conseil d’Analyse Economique), the report first underlines that the man drivers of biodiversity loss are now well identified (artificialisation of soils, fragmentation of natural environments, intensive farming practices, draining of wetlands). However, authors point out that “biodiversity preservation policies show disappointing results and main issues have been underestimated for too long”. They lack coherence and are based on protection schemes that are too fragmented, and focus too often on species or animals rather than on full ecosystems.

According to the report, instruments exist to make better use of dedicated budgets, to make regulations more coherent and ambitious and to provide effective incentives for protection. Authors therefore recommend to:

- Include large investments in biodiversity-friendly development actions in the Recovery Plan in response to the Covid-19 crisis, according to a unified national strategy. Different territorial levels can implement this strategy effectively linking the missions of the French biodiversity office, regional structures and local authorities.

- A renewed range of instruments inspired by an economic approach needs to be implemented, with an objective to better account for the positive externalities of biodiversity. Authors recommend a reform of the “avoid, reduce, compensate” sequence currently in force in major development projects as well as a more conditional access to public subsidies. They also propose a review of tax systems to reduce the actual incentives to artificialize soils (e.g. excessive taxation of non-built areas; failure to take into account the cost of artificialisation in development projects; review of agricultural subsidies);

- They also recommend making the biodiversity-related environmental clauses of preferential trade agreements more operational and encouraging coordinated policies, by integrating all the measures into a global framework for changing consumption patterns, particularly of animal products, and reducing waste.

Worth noting that efforts to establish a Task Force on Nature-related Financial Disclosures (TNFD) has passed an important milestone with the recent announcement of an Informal Working Group comprising some of the world’s biggest banks, investors and companies, as well as governments and regulatory bodies. This is the start of the initial planning phase of the TNFD, tasked with establishing a detailed work plan for the Task Force for when it launches in 2021. As data gaps currently prevent financial institutions from assessing their nature-related risks, the TNFD will build awareness and capacity to enable the financial sector to address the market and systemic failures contributing to the destruction of nature.

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Extra readings :

- By Bloomberg Intelligence, a recent article has pointed out the potential of ESG to turn into a refuge class, such as gold and metal, especially since it is currently benefitting from a wider investor pool (i.e. growing sophistication and range of products – equities, high yield credit, real estate strategies; U.S awakening and associated inflows). Unlike gold, ESG is supposed to offer exposure to growth, and can sustain performance – helped by current fiscal stimulus programs that are seeking to reduce fossil-fuel dependence. As of today, ESG ETF flows therefore dominate over smart beta strategies globally, according to the article;

- In a recent article, two experts from the International Finance Corporation have pointed out the differences between ESG and impact investment strategies in financial markets, contributing to the debate by underlying that “both can deliver superior financial performance and make the world a better place, but they work in different ways, and there are some overlaps between the two strategies”. Despite commonalities, there are three requirements of investors to ensure their investments are impact investments and not ESG: a selection of assets with intent for impact; a contribution to the impact of the investee firm; and an objective measurement of that impact;

- Former IIRC Chair Richard Howitt has published an article on ongoing efforts to achieve a set of widely accepted standardized indicators for companies, reacting to the publication of “common metrics for stakeholder capitalism” by the World Economic Forum, the setup of a European task force to define ESG reporting standards and a “statement of intent” towards greater collaboration from the five largest sustainability and integrated reporting frameworks. Richard Howitt raises three main conclusions: (i) touchstone issues such as science-based targets, resource circularity, business and human rights issues should not be excluded from comparable and consistent reporting; (ii) existing collaborations need to remain open to new players in the field (World Benchmarking Alliance, Impact Management Project…); and (iii) ESG reporting design must integrate the notion of “impact”, as too much of existing sustainability reporting addresses risks and policies in ESG, but not actual targets or results, in this new era when impact is the true ultimate goal;

- The Financial Times has recently raised in a compelling article that while food is at the nexus of practically every major sustainability issue, making the sector an obvious focus for ESG investors, the latter are finding it hard to incorporate food in their portfolios. Food businesses’ far-reaching impacts are indeed difficult to measure, making it unclear whether they meet ESG criteria (“food companies’ complex operations can leave investors scrambling to keep track of what they are doing. Their exposure to risk may also be much greater than appears at first glance. While they may not emit that much carbon themselves, for example, their supply chains often do. Public health is another source of substantial risk”).