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

The year 2021 is off to a great start in terms of sustainable and climate finance, notably with the return of the United States to the international scene, as well as abundant research on climate scenarios and financial stability. At the same time, a recent study published in Nature Climate Change (available here) predicts that the CO2eq already circulating in the air will push global temperatures to about 2.3°C of warming since pre-industrial times, making efficient policies and innovative action a pressing need. Below is our selection of literature by Policy Shift to finish the month of February.

Across the pond: recent developments for U.S sustainable finance

The presidency of Joe Biden (this article (and videos) by the New York Times published on December 14, 2020 is comprehensive) and recent pledges on carbon neutrality – notably by China (this memo by the French Institute for International Relations is worth the read) – have raised hopes for 2021 for a greater response to the climate crisis, though the world is still heading for a temperature rise in excess of 3°C this century according to the UN (UN Emissions Gap Report available here, dated December 9th, 2020).

U.S Climate Finance is therefore approaching a “leapfrog moment”, according to the most recent tribune by Duke Professor and Deputy U.S Treasury Secretary Sarah Bloom Raskin.

On January 27th, 2021, Joe Biden signed a presidential decree (see the factsheet here), announcing the organization of a leaders' summit on climate, which should take place on April 22, 2021. In addition, President Biden called for the implementation of a new nationally determined contribution of the United States, in accordance with the Paris agreement, as part of the above-mentioned summit, as well as institutional arrangements in order to mobilize cross-cutting and interdepartmental action on climate. The willingness to join the Kigali Amendment to the Montreal Protocol (HFC gas) is stated, and the decree underlines that the U.S climate change strategy will be based on the best available scientific information. From a practical point of view, this presidential decree creates a White House Office of Domestic Climate Policy and a National Climate Task Force, bringing together leaders from 21 Federal departments and agencies to enable an intergovernmental approach to combat the climate crisis, with each federal agency developing a plan to adapt its facilities and operations to climate change.

Despite the fact the Executive Order has been praised (here), big challenges still lie ahead (here), most notably on the fossil industry side – especially gas. For an insightful overview, a November 2020 article by economist Christian de Perthuis (here) is worth the read (on carbon neutrality by 2050, the full decarbonization of electricity production by 2035 and the end of thermal vehicles, divestment from fossil fuels…). A detailed roadmap for achieving a carbon-free economy by 2050 has been released recently by the U.S. Academy of Sciences, calling on the United States to invest $2 trillion over the next decade to initiate transitions in energy, innovation and manufacturing (available here).

The rebuilding of the Environmental Protection Agency (EPA) is also underway. This memo published in the Nature Review on the EPA, points out ways to rebuild the institution after the Trump presidency (“The EPA has lived through the most dangerous period of its 50-year history — Biden’s administration has the chance to ensure that the agency is never put in the same position again”).

On the financial side, several articles are worth pointing out, including this synthesis (here) :

• The Federal Reserve – that has recently joined the Network for Greening the Financial System – dedicated for the first time in history, room on the implications of climate change for financial stability in its recent Financial Stability Report. The report points out that a wide range of policies could moderate climate-related financial vulnerabilities (increased transparency to improve their pricing; continued research into the interconnections between climate, the economy and the financial sector…). It underlines that the Fed is “evaluating and investing in ways to deepen its understanding of the full scope of implications of climate change for markets” and that it expects “banks to have systems in place that appropriately identify, measure, control, and monitor all of their material risks, which for many banks are likely to extend to climate risks”;

• While the U.S. Federal Reserve has announced the creation of a Supervision Climate Committee to deepen the Central Bank's understanding of the risks that climate change poses to the financial system, Governor Lael Brainard has made a valuable speech on February 18, 2021, pointing out the economic consequences of climate change (through physical and transition risks) and the role of supervisors in ensuring that financial institutions are resilient to all material risks, including those related to climate change, both currently and into the future. Underlining the uncertainty of climate-related financial risks (in timing, magnitude and linearity), she presented data, disclosures and modelling techniques as crucial tools to reduce these uncertainties, in addition to the role of governance, risk identification (through scenario analysis) and risk management processes;

• Climate change has also recently been recognized as a financial risk by the Federal Reserve Bank of San Francisco (here) and the Chicago Federal Reserve (here);

• The Biden administration has announced it would reverse the Department of Labor rule aimed at curbing the use of ESG funds in retirement plans (here). This rule, enacted under the Trump administration, had been highly criticized, as it required fiduciaries selecting ESG funds to separate the use of risk-return factors from investments that promote non-pecuniary benefits or objectives;

• The U.S Climate Finance Working Group, comprised of financial services trade associations (e.g. IIF, ISDA, ICMA…) published a set of principles to finance a U.S transition to a sustainable low-carbon economy (here). The objectives include: setting science-based climate policy goals that align with the Paris Agreement; fostering international harmonization of taxonomies, data standards and metrics; and ensuring a risk-based climate-related financial regulation, among others.

• A notable challenge centers on corporate governance and climate expertise. This paper by Tensie Whelan (NYU Stern Center for Sustainable Business) reviewed over a thousand individual Fortune 100 board members’ credentials to determine whether companies with material ESG risks and opportunities had relevant expertise on their boards. The study has found that very few sectors and companies are adequately prepared at the board level for issues that were already affecting their performance, even though corporate sustainability and ESG investing are increasingly at the forefront for U.S. companies.

On international cooperation and climate finance

• Last December, economist Christian de Perthuis published an article here (in French) on the anniversary of the Paris Agreement, detailing three drivers for greater international climate action, i.e. (i) the increased competitiveness of renewable energies allowing for increased access to energy in developing countries and reducing the reliance on fossil fuel sources; (ii) the election of Joe Biden and his climate plan, that could incentivize fossil fuel companies to fully engage in the energy transition; and (iii) the efforts of the rest of the world that could be spurred by the EU Green Deal and China’s carbon neutrality plan.

In the same vein, this article by Martin Wolf published in the Financial Times, entitled “We can avert irreversible climate change”, points out that cooperation among five players — China, the US, the EU, India and Japan — would deliver a huge part of what is needed in terms of reduction of greenhouse gas emissions. He underlines: “The only realistic hope is technocratic problem-solving and co-operative policies. These must be guided by moral purpose, but not infused by fantasies of revolutionary transformations. Cries of “repent, for the end of the world is nigh” will not solve this emergency. Humanity is at its best when it uses its head. Climate is at bottom a crisis of technology and behavior; it can be tackled only by changing incentives throughout the system”.

• This article by Liu and Raftery, published in Communications Earth and Environment in February 2021, shows that the probabilities of meeting their nationally determined contributions for the largest emitters are low, e.g. 2% for the USA and 16% for China. On current trends, the probability of staying below 2 °C of warming is therefore only 5%, but if all countries meet their nationally determined contributions and continue to reduce emissions at the same rate after 2030, it rises to 26%. If the USA alone does not meet its nationally determined contribution, it declines to 18%. To have an even chance of staying below 2 °C, the average rate of decline in emissions would need to increase from the 1% per year needed to meet the nationally determined contributions, to 1.8% per year.

• This article published in Nature Climate Change in February 2021, entitled “Rebooting a failed promise of climate finance”, underlines the difficulties posed by the 2009 pledge of $100 billion per year, given the diversity of sources of funding – public and private, bilateral and multilateral, including alternative sources of finance – and no rule on what could be counted in these categories. The article argues that a post-2020 model should build on clear rules on what counts as climate finance, and realistic assessment of developing countries’ needs.

Why disclosure is far from being "enough": recent research

• By Madison Condon (Associate Professor, Boston University School of Law), an article published in February 2021 and entitled “Market Myopia’s Climate Bubble” argues that underpricing of corporate climate risk exacerbates the negative effects of climate change itself, as the mispricing of risk in the present leads to a misallocation of investment capital, hindering future adaptation and subsidizing future fossil combustion. These risks could accumulate to the macroeconomic scale, generating a systemic risk to the financial system. While a broad array of government interventions are necessary to mitigate climate related financial risks, Condon focuses on proposals for corporate governance and securities regulation—and their limits. While signals from the Biden Administration indeed suggest that mandatory climate risk disclosure regulation from the Securities and Exchange Commission is forthcoming, the study argues that climate risk disclosure is necessary, though alone not sufficient, to address the widespread disregard of corporate climate exposure. “These institutions have already been advocating for increased disclosure of climate risks. While they may not rely on the information to make trades, they should integrate climate risks into their governance oversight of portfolio companies. This may include taking a portfolio perspective, and seeking direct mitigation of climate risk itself through pressuring companies to reduce their emissions”.

• This article relates to a study by Ameli, Drummond, Bisaro and Chenet in Climate Change in 2020, entitled “Climate finance and disclosure for institutional investors: why transparency is not enough”. The article argues that the while the implicit assumption of disclosure (i.e. if risks are fully revealed, finance will respond rationally and in ways aligned with the public interest) is rooted in the efficient market hypothesis, the latter is unsupported by either theory or evidence; hence transparency alone is an inadequate response. The study employs the Three Domains framework (Grubb et al., 2014) of economic decision-making, and uses empirical evidence (from a survey of institutional investors), to probe some of the limits of the efficient market hypothesis. Therefore, though it can address behavioral biases and improve pricing and market efficiency, it suffers from strategic limitations.

• A study published in December 2020 by de Bettignies and al. entitled “Corporate Social Responsibility and Imperfect Regulatory Oversight: Theory and Evidence from Greenhouse Gas Emissions Disclosures”, has developed and tested a model in which purpose-driven firms emerge as an optimal organizational form even for profit-maximizing entrepreneurs; and CSR arises endogenously as a response to imperfect regulatory oversight.

Publications on climate risk and scenario modelling

One of the next frontiers of sustainable finance, climate risk modelling and management, is a rising topic in economic and management literature.

Along these lines, asset manager BlackRock, has published a commentary on climate risk and the transition to the low-carbon economy in which it asks investee companies to have “clear policies and action plans to manage climate risks”, and tells them it may vote against company directors that fall short. BlackRock may consider whether a company stress tests its assets under a less than 2°C scenario, how it maps current and future emissions, and its plans to adjust its strategy to account for physical and transition risks when assessing their overall approach to climate issues. The asset manager said it could also support shareholder proposals “that we believe address gaps in a company’s approach to climate risk and the energy transition”.

Another notable article published in Nature Climate Change, entitled “Business risk and the emergence of climate analytics” focuses on emerging awareness of climate-related financial risk, and has prompted efforts to integrate knowledge of climate change risks into financial decision-making and disclosures. However, assessment of future climate risk requires knowledge of how the climate will change on time and spatial scales that vary between business entities. Yet, the rules by which climate science can be used appropriately to inform assessments of how climate change will impact financial risk have not yet been developed.

• This report by the Institute for Climate Economics, published in February 2021, aims at identifying – and providing tools on how to address – physical risks. While the black box of climate services has now been partly opened (still requiring service providers to improve the transparency on methodological choices), financial actors are increasingly understanding that physical impacts of climate change are already being realized with damage costs. Though navigating the multitude of data sources is complex, the report aims at providing guidance to identify the relevant data for physical risk assessment and quantification. The report shows that increased capacity building, pilot risk assessments and the mobilization of a broader ecosystem on climate risk management are utterly needed;

• This report published by UNEP-FI in February 2021 provides an assessment of existing transition and physical risk tools and analytics (about 20 of them), showing that regulatory and technology developments will encourage the broader use of reference scenarios and combined physical and transition risk methodologies. Challenges in 2021 will be about increasing standardization and mainstreaming, the adaptation of methodologies to carbon lock-in and so-called “knock-on” impacts of climate risk (economic, public health and migration-related) as well as biodiversity risk. They constitute, according to the report, a “considerable blind spot” and “are difficult to model” because of human behavior and the unpredictability of health crises. Given that financial institutions will “increasingly want to integrate climate risk into their financial and economic decision-making tools”, which would make them leery of using third-party ‘black box’ models;

• This report published by UNEP-FI in February 2021, untitled “Pathways to Paris”, aims to stand as a guide for all financial sector stakeholders and scenario users seeking to better understand climate scenarios. It explains the mechanics of the integrated assessment models used to produce scenarios, explores some of the material assumptions that differentiate the underlying models and scenario pathways from each other (including macroeconomic, energy and technology as well as policy assumptions) and discusses how major economic sectors are incorporated into the IAMs and at what level of granularity.

Carbon sinks as a rising topic in sustainable finance

While the levels of CO2 in the atmosphere, land and ocean continue to rise, emissions from land-use change do not show significant decline, as shown by a recent carbon outlook on 2020 greenhouse gas emissions (here). Enhancing the role – carbon capture and storage capacity – of organic carbon sinks is an increasingly important topic in greening financial decision-making. In this context, a few recent articles/reports are worth noting:

• This report by UNEP-FI on “ocean finance”, published in February 2021, specifies the role of financial markets in the “blue economy”, as it must encompass environmental stewardship, in a context where the ocean is at breaking point, faced with the triple crises of pollution, nature loss and climate change. Through their lending, underwriting and investment activities, as well as their client relationships, financial institutions have the power to accelerate and mainstream the sustainable transition of ocean-linked industries;

• This article published in Nature Climate Change in January 2021 emphasizes the role of forest management for climate change mitigation. Whereas, to date, several forest carbon monitoring systems have been developed for different regions, the use of various data, methods and assumptions has made it difficult to evaluate mitigation performance consistently across scales. The study has mapped annual forest-related greenhouse gas emissions and removals globally at a spatial resolution of 30 meters over the years 2001–2019, estimating that global forests were a net carbon sink of −7.6 ± 49 GtCO2e yr−1, equivalent to 1.5 times the annual carbon emissions from the U.S. The authors emphasize that this geospatial monitoring framework can support climate policy development by promoting alignment and transparency in setting priorities and tracking the progress of forest-specific climate mitigation goals at the local and global level. It can also identify contributions of various forest types, with tropical forests absorbing and emitting carbon more than any other forest type due to deforestation and degradation;

• This article published by Gattuso and al. in 2021 deals with the effectiveness, feasibility, duration of effects, co-benefits, cost effectiveness and governability of four ocean-based negative emissions technologies. The article underlines their role in revising UNFCCC Parties' future Nationally Determined Contributions (NDCs), in the broad context of ocean-based actions for both mitigation and ecological adaptation. Among the 161 initial NDCs submitted in 2014–2015, 70% only mentioned marine issues, most frequently as components of adaptation action or in regard to climate impacts, and just over a third also included ocean-related mitigation measures (with the only ocean-based negative emission approach specifically mentioned being the conservation and restoration of coastal blue carbon ecosystems). Though they are uncertain, the article underlines their potential to be highly effective.

A few bonus readings !

• On climate change vulnerability and sovereign credit ratings, a blog post by the IMF published on February 17, 2021 (based on the report “Feeling the heat: climate shocks and credit ratings” available here) is worth the read. By means of binary-choice models, the report finds that climate change vulnerability has adverse effects on sovereign credit ratings, after controlling for conventional macroeconomic determinants of credit worthiness. On the other hand, countries with greater climate change resilience benefit from higher (better) credit ratings. These findings also show that impact of climate change is disproportionately greater in developing countries due largely to weaker capacity to adapt to and mitigate the consequences of climate change;

• On the meaning of the term “transition” in ecological transition, an insightful article published in The Conversation (here) by philosopher Catherine Larrère;

• On the role of financial regulation in accelerating the low-carbon transition, an interesting report by the Institute for Climate Economics published in February 2021, with a myriad of proposals on stepping up training of financial actors; encouraging the development of simple tools to understand the transition; the integration of the challenges of the transition into remuneration policies; transparency of financial indexes; the mobilization of household savings; the broadening of fiduciary responsibility; and prudential regulation;

• On the decoupling of economic growth and resource consumption, this valuable report from the European Environmental Agency, entitled “Growth without economic growth” emphasizes that such decoupling may not be possible and underlines the alternatives such as doughnut economics, post-growth and de-growth theories. It shows that changes in consumption, social, political and institutional practices are required, with a need to address existing barriers democratically;

• On the everlasting debate on the “greenium” in green bond issuance, this recent paper by Löffler, Petreski and Stephan in the Eurasian Economic Review is insightful, both for its literature review and its contributions to the debate thanks to its introduction of a more robust nonparametric matching method (less susceptible to bias), as well as by using a sample of bonds encompassing later stages of the marker (to detect if the green bond premium persists in more recent years now that the market has begun to mature), and by relating the yield of green bonds in the primary market to the second market. Using a universe of about 2000 green and 180,000 non-green bonds from 650 international issuers, the study finds that green bonds have larger issue sizes and lower rated issuers, on average, compared to conventional bonds. The estimates show that the yield for green bonds is, on average, 15–20 basis points lower than that of conventional bonds, both on primary and secondary markets, thus a “greenium” exists.