This journal section indicates a few and briefly commented references that a non-expert reader may want to cover to obtain a first informed and broad view of the theme discussed in the current issue. These references are meant to provide an extensive, though not exhaustive, insight into the main topics of the debate. More detailed and specific references are available in each article published in the current issue.

On the relevance of climate change risks

Understanding the effects of climate change on the financial system has emerged as one of the forefront issues globally (Hong et al., 2019, 2020). Climate change is believed to increase the frequency and intensity of extreme weather events, raise average temperatures, and rising sea levels. Importantly, climate change already impacts economic and financial outcomes, which might have negative repercussions on financial systems. Correlated risks from climate change shocks could have effects beyond individual banks and borrowers to the broader financial system and economy. In this regard, in the pricing of residential mortgages does not incorporate climate change risks, a sudden correction could result in large-scale losses to banks, leading to reduced lending supply and jeopardizing financial stability. The subsequent declines in wealth could amplify the effects of climate change on the real economy, thus producing knock-on effects on financial markets (Nguyen et al., 2021).

Financial institutions must assess their vulnerabilities to relevant climate risks, as well as risks’ likely persistent and breadth, to be able to continue meeting the financial needs of households and companies when hit by disruptions caused by climate change. Remarkably, considering climate risks is relevant from the regulatory point of view. In this vein, the Federal Reserve created a dedicated supervision climate committee to observe the risks of climate change to individual banks. Likewise, the Bank of England expects its banks to understand and assess the financial risks related to climate change (Nguyen et al., 2021).

The recent studies are focused on exploring the ex-post effects of acute hazards, e.g., storms, floods, wildfires, on banks. In this regard, North and Schüwer (2018) show that natural disasters weaken financial stability. Similarly, Issler et al. (2020) find an augment in mortgage delinquency and foreclosure after wildfires. Ouazad and Kahn (2021) find that lenders are more likely to approve mortgages that can be securitized after hurricanes. Unlike acute hazards, the chronic ones -e.g., slow increases in sea levels- introduce the possibility that losses may arise from natural disasters. Despite the risk of chronic hazards causing losses, economists still know little about how such risks are priced ex-ante by banks. Consequently, more research is needed to understand how climate risk can be priced -ante by financial institutions, particularly the pricing of loans.

Interestingly, banks may not be able to price long-term climate change risks. The Board of Governors of the Federal Reserve System (2020a, b) estates that banks’ models still lack the necessary geographic precision or horizons to price climate risks. Another challenge can be uncertainty regarding the time horizon over climate risk can be materialized (Barnett et al., 2020). Furthermore, many banks still rely on traditional backward-looking models based on historical exposures, which might not adequately reflect climate risks’ complex and continuous changing nature. Moreover, considering the set of risks that banks are currently facing -e.g., cybersecurity, geopolitical risks, and risks associated with the credit cycle-along with the relative long-term horizon around climate change and risk (Nyberg and Wright, 2015). For instance, sea levels rise is a non-conventional risk and therefore, lenders pay equal attention to this risk or incorporate it into their pricing loan decisions (Jiang et al., 2020).

On carbon pricing and its repercussions on lending

Research on carbon risk is still embryonic. Stranded assets are physical assets whose value declines substantially due to climate risk. The carbon reduction requirements in the Paris Agreement and the policies oriented to fossil fuel firms might not be able to fully utilize their existing fossil fuel reserves (McGlade and Ekins, 2015), leading to a decline in the financial values of such reserves. The carbon risk from stranded assets in the fossil fuel industry can be priced, which constitutes an approach for assessing climate-related financial risks. However, carbon risk goes beyond stranded assets. Firms issuing large volumes of carbon are relatively more likely to suffer financial penalties if environmental policies tighten. Direct penalties can result from additional costs of carbon taxes on firms’ emissions. These can apply to firms in all industries with a carbon footprint and are not limited to fossil fuels producers (Ehlers et al., 2021).

The pricing of carbon risk in the loan markets changed significantly after the Paris Agreement.^[1]See the Institutions section in this issue. The difference in risk premia due to carbon emission intensity is apparently across industry sectors. Additionally, this phenomenon is broader than simply stranded assets in fossil fuel emissions or other carbon-intensive industries. Including loans fees and the premium is not prevalent in the years before the Paris Agreement, which increased banks’ awareness of carbon risk (Krueger et al., 2020). However, Delis et al. (2021) assess syndicated loan data for fossil fuel firms to investigate whether banks price the risk of stranded assets.^[2]The corporate loan market, and specially the syndicated loans markets, constitutes an ideal laboratory to test hypotheses about the effects of climate change / risk on loan pricing, because banks … Continue reading They reveal that only after the 2015 Paris Agreement banks started pricing the risk of stranded assets related to fossil fuel reserves. Similarly, Kleimeier and Viehs (2018) also use syndicated loans data to investigate if forms voluntarily disclose their carbon emissions to the Carbon Disclosure Project, which allows them to reduce their cost of credit compared to non-disclosing firms. This result supportcs Antoniou et al. (2020), who theoretically find that loans spreads for firms participating in cap-and-trade programs function the cost of compliance and the specific features of the permits markets. Using the EU Emission Trading System, which is designed to pass the cost of CO2 emissions to polluters, this study suggests that the higher permits storage and lower permit prices, the lower firm financing costs.

Importantly, banks have started to internalize possible risks from the transition to a low-carbon economy across various industries. Krueger et al. (2020) suggest that carbon emissions indirectly caused by production inputs were not priced at the margin, suggesting that the overall carbon footprint is less of a concern to banks those direct missions. Likewise, Bolton and Kacperczyk (2021) find that the likelihood of disinvestment by institutional investors significantly augments with the degree and intensity of emissions directly attributable to firms. This suggests potential for ‘green-washing’ since the aforementioned emissions mentioned above can be reduced simply by outsourcing carbon-intensive activities withoutlowering the firm’s carbon footprint (Ben-David et al., 2018).

On the impact of climate change on equity markets

So far, research on the pricing of climate change risk, including carbon risk, has focused on the pricing of climate-related risks in equity markets. Recently, economists indicated that a transition risk premium in equity and option markets, which seems to be more pronounced in times of high climate change awareness. Mainly, the price of protection of option securities against the downside tail risk is higher for carbon-intense firms. In this regard, Bolton and Kacperczyk (2021) identify a carbon premium in the cross-section of the US stock market over the last decade. Particularly, the 2016 US climate policy shocks (the Trump election who appointed Scott Pruit, a climate sceptic, as administrator of the US Environmental Protection Agency) provide additional evidence that firms’ exposure impacts on their stock market valuation (Ramelli et al., 2021). Consequently, the valuation of carbon-intense firms rose. Goergen et al., (2020) assess carbon risk measures based on the firm’s overall strategy and its operational exposure to transition risk, including carbon emissions. Although they find that carbon risk is a priced risk factor, it does not find any evidence for a carbon premium in the global equity market.

On the capacity of banks to boost the climate change

As major providers of credit, banks are the key players in the effort to transition from a brown to a green economy. The momentum established by the COP21 enlarges the set of investment opportunities to finance green projects and renewable energy. Indeed, investment in the green economy has recently increased and is expected to grow enormously in market share (IEA, 2015; International Renewable Energy Agency, 2016). This increase is motivated by a growing consensus that supports movements towards a low-carbon economy and technological improvements that will lead to cost reductions in renewable energy, making alternatives to fossil fuel more appealing (Mazzucati and Perez, 2015; Krueger et al., 2015).

This might raise the question of how climate risks might directly impact financial institutions. Importantly, banks take on new risks in this regard, particularly physical and transition risks. On the one hand, physical risks arise from weather and climate-related disasters (Nordhaus, 1977; Stern, 2008; Nordhaus, 2019). These events can damage properties, reduce agricultural productivity, and impact deleteriously on human assets (Deryugina and Hsiang, 2014; O’Neil et al., 2017). Should this reduce the firms’ profitability and deteriorate their balance sheets, banks would be negatively affected in terms of asset values, collateral quality, and credit risk exposure. Furthermore, banks suffering large losses could diminish their lending availability, thus exacerbating the financial impact of physical risks by reducing credit supply. The blossoming literature provides theoretical and empirical evidence that banks should consider such physical risks in their investment decisions. Accordingly, Addoum et al. (2019) and Pankratz et al. (2019) show a negative correlation between firms exposed to extreme temperatures and profitability. Balvers et al. (2017) find that firms suffering from relatively high temperatures have higher cost of capital. This result connects with the literature advocating that extreme weather events are incorporated to stock and option markets (Dell et al., 2014; Kruttli etal., 2019; Choi et al., 2020).

On the other hand, banks should face transition risks that might arise from adjustments made toward developing a green economy. Particularly, transition risk depends on the timing and the speed of the process. Unanticipated changes in climate polices, regulations, technologies, and market sentiment could reprice the value of bank assets (CISL, 2019; Hong et al., 2019). Consequently, banks exposed to climate-sensitive sectors might be forced to fire carbon-intensive assets, leading to liquidity problems (Pereira da Silva, 2019). Therefore, this could create uncertainty and procyclicality and increase banks’ market risk (BoE, 2018). Transition risks could impact on bank credit risk if new technologies or changes in consumer behaviour towards “environmentally friendly” sectors lowered carbon-intensive firms’ profitability, further increasing their default risk (Krueger et al., 2020). Reghezza et al. (2021) analyse whether climate-oriented regulatory policies impact the flow of credit towards polluting corporations. Following the Paris Agreement, they find that European banks reallocated credit away from polluting companies. Consequently, green regulatory initiatives in banking can significantly impact on combating climate change.

Importantly, the COP21 is expected to impact the banking sector’s decisions. De Greiff et al. (2018) and Degryse et al. (2020a, b) assess the effect of climate risks on pricing in the syndicated loans. Since the COP21, banks have charged a premium for climate risk driven by increased awareness of climate policy-related risks. In particular, green firms have borrowed at comparatively lower prices since COP21 came into force.
Likewise, Delis et al. (2018) analysed the risk stemming from stranded fossil reserves, suggesting that, after 2015, banks started to price climate policy exposure by raising the cost of credit due to their awareness of transition risk. Ilhan et al. (2018), using a sample of high-emission industries in the S&P 500 before and after COP21, find that investors already incorporate information on climate-related risks when assessing risk profiles. Ginglinger and Moreau (2020) show that, after COP21, French companies subject to large climate risks reduced their leverage.

Regarding the financial system structure, De Haas and Popov (2019) find evidence of relatively lower CO2 emissions in more equity-funded economies, and they argue that stock markets contribute to reallocating investments toward less polluting industries. Similarly, Mesonnier (2019) investigates whether French banks reallocate credit from low intensive industries over the 2010-2017 period. They find that French banks reduce credit provision to more polluting industries.

References

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Barnett, M., Brock, W., and Hansen, L. P. (2020). Pricing uncertainty induced by climate change. Review of Financial Studies, 33: 1024-1066.

Ben-David, I., Franzoni, F., and Moussawi, R. (2018). Do ETFs Increase Volatility? Journal of Finance, 73: 2471-2535.

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BoE (2018). Transition in thinking: The impact of climate change on the UK banking sector. Bank of England Report, September 2018.

Bolton, P., and Kacperczyk, M.T. (2020). Do investors care about carbon risk? Journal of Financial Economics, 142: 517-549.

Choi, D., Gao, Z., and Jiang, W. (2020). Attention to global warming. The Review of Financial Studies, 33: 1112-1145.

CISL (2019). Unhedgeable risk: How climate change sentiment impacts investment. Cambridge Institute for Sustainability Leadership, Cambridge.

De Greiff, K., Ehlers, T. and Packer, F. (2018). The pricing and term structure of environmental risk in syndicated loans. Mimeo, Bank for International Settlements.

De Haas, R. and Popov, A. (2019). Finance and Carbon Emissions. ECB Working Paper Series, No 2318. Available at: https://www.ecb.europa.eu/pub/pdf/scpwps/ecb.wp2318~44719344e8.en.pdf (Accessed on February 2, 2022).

Degryse, H., Goncharenko, R., Theunisz, C. and Vadasz, T. (2020). When green meets green. Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=16536

Degryse, H., Roukny, T. and Tielens, J. (2020), Banking barriers to the green economy. NBB Working Papers, No 391. Available at: https://www.nbb.be/en/articles/banking-barriers-green-economy (Accessed on February 2, 2022).

Delis, D. de Greiff, K., Iosifidi, M., and Ongena, S. (2021). Being Stranded with Fossil Fuel Reserves? Climate Policy Risk and the Pricing of Bank Loans. Swiss Finance Institute Research Paper No. 18-10. DOI: http://dx.doi.org/10.2139/ssrn.3125017

Delis, M., De Greiff, K., and Ongena, S. (2018). Being stranded on the carbon bubble? Climate policy risk and the pricing of bank loans. Swiss Finance Institute Research Paper Series, No 18-10, Swiss Finance Institute. DOI: http://dx.doi.org/10.2139/ssrn.3125017

Dell, M., Jones, F. B., and Olken, B. (2014). What do we learn from the weather? The new climate-economy literature. Journal of Economic Perspective, 52: 740-798.

Deryugina, T., and Hsiang, M. S. (2014). Does the environment still matter? Daily temperature and income in the United States. NBER Working Papers, No 20750, National Bureau of Economic Research, December. DOI 10.3386/w20750

Ehlers, T., Packer, F., and Greiff, K. (2021). The pricing of carbon risk in syndicated loans: which risks are priced and why? BIS Working Papers No 946. Available at: https://www.bis.org/publ/work946.pdf (Accessed on February 2, 2022).

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Issler, P., Stanton, R., Vergara-Alert, C., and Wallace, N. (2020). Mortgage Markets with Climate-Change Risk: Evidence from Wildfires in California, Working paper. DOI: http://dx.doi.org/10.2139/ssrn.3511843

Jiang, F., Li, C. W., and Qian, Y. (2020). Do costs of corporate loans rise with sea level? Working paper. DOI: http://dx.doi.org/10.2139/ssrn.3477450

Kleimeier, S., and Viehs, M. (2018). Carbon Disclosure, Emission Levels, and the Cost of Debt. DOI: http://dx.doi.org/10.2139/ssrn.2719665

Krueger, P., Sautner, Z., and Starks, L.T. (2020) The Importance of Climate Risks for Institutional Investors. The Review of Financial Studies, 33: 1067–1111.

Kruttli, S. M., Tran, R. B., and Watugala, W. S. (2019). Pricing Poseidon: Extreme weather uncertainty and firm return dynamics. Finance and Economics Discussion Series, No 2019-054, Board of the Federal Reserve System.

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Recent international commitments to climate change

The United Nations (UN hereafter) Climate Change Conference (COP26), which was held in Glasgow (UK), brought together many of the world’s leaders to address concerning issues related to climate change. The headline decision of COP 26 was the Glasgow Climate Pact, an initiative of the UK COP Presidency to capture progress beyond the formal agenda. The Intergovernmental Panel on Climate Change (IPCC) released a report in 2018 that identified that global emissions would need to reduce to zero level by at least 2050 to retain a ‘high-confidence’ level to limit the rise of temperatures to sustainable levels (Masson-Delmotte et al., 2018). The US Treasury Secretary Janet Yellen stated that “rising to this challenge will require the wholesale transformation of our carbon-intensive economies” and that “addressing climate change is the greatest economic opportunity of our time.” (COP26, 2021; Depledge et al., 2022).^[1]The World Economic Forum and PwC released jointly the Harnessing Technology for the Global Goals report that identified the significant role that digital technology can play in improving resilience … Continue reading

On the heels of the COP26 Finance Day, the banking industry leaders also met in Glasgow to discuss the leadership role of the banking sector toward net-zero emissions.UN-convened Net-Zero Banking Alliance also committed to coordinating climate actions for financial institutions and aligning their lending and investments portfolios with zero-net emissions by 2050. At the time of writing this note, the Alliance brings together around 100 banks worldwide, representing over 40% of global banking assets. The Alliance acknowledges the crucial role of banks in supporting the transition of the real sector to a greener economy (see Beyene et al., this issue).

The European Commission’s sustainable finance strategy

The High-Level Expert Group on sustainable finance was created in 2016 and included members from the civil society, the financial sector, and the Academia from international institutions.^[2]The European Commission defines sustainable finance as the process of dully taking environmental and social contemplations into account when making long-term decisions in sustainable activities … Continue reading Notably, the 2018 group’s final report established the pillars for the Action Plan on Financing Sustainable Growth, which is intended to develop the European Union’s sustainable finance strategy and to incorporate environmental, social, and governance (ESG) considerations into the European financial system (European Commission, 2019, González-Martínez, 2021). The Taxonomy Regulation (Regulation (EU) 2020/852 of June 2020) is the cornerstone of the whole Action Plan since it establishes the classification system for the ‘sustainable’ economic activities.^[3]See also Regulation (EU) 2019/2088 and Regulation (EU) 2019/2089.^[4]In this regard, the European Commission introduced two supplements. First, the Commission Delegated Regulation (EU) 2021/2139 supplements Regulation 2020/852 by establishing the technical screening … Continue reading Interestingly, the EU Ecolabel for retail financial products is dedicated to expressing investors’ preferences regarding sustainability and the more straightforward access to sustainable products.

Disclosures

The Financial Stability Board created the Task Force on Climate-related Financial Disclosures (TCFD), which provides recommendations for assessing and reporting their climate-related strategy.^[5]Disclosures of the financial impacts of climate-related and environmental risks are crucial for achieving the transparency necessary to preserve market discipline. In other words, promoting peer … Continue reading In particular, the final report makes sector-specific recommendations on how companies should disclose climate-related financial risks to inform better their investors, lenders, and insurers (Campiglio, 2016; Campiglio et al., 2018). Notably, the PCAF Global Greenhouse Gas Accounting and reporting Standard for the Financial industry offers detailed statistics on measures and disclose emissions for specific assets. The Science Based Target initiative (SBTi) published the Financial Sector Science-Based Targets Guidance which enables companies to set emissions reductions targets according to the foremost climate science (SBTi, 2021).

The European Commission adopted in April 2021 a proposal for Corporate Sustainability Reporting Directive (CSRD) that introduces stricter reporting requirements and widens the scope of applicability with respect to the existing non-financial reporting directive (NFRD). Furthermore, Regulation (EU) 2019/2088 will apply from March 2021. Regarding the development of a European Union Green Bond Standard, in early July 2021 the European Commission presented its proposal based on a voluntary framework that remarks transparency, the need for external review, and the European Securities and Markets Authority should supervise it.

Remarkably, integrating ESG risks into the Supervisory Review and Evaluation Process (SREP) performed under the Pillar 2 as not exempt from difficulties. However, the EC has considered these recommendations in developing the EU Banking Package that finalises the implementation of Basel III in Europe. Formally, Pillar 3 disclosure requirements are expanded from applying to large, listed institutions to all in the scope of the CRR (EBA, 2021; Marullo Reedtz, this issue). Importantly, as a part of the Pillar 3 disclosure and the NFRD, the Green Asset Ratio measures the “greenness” of the bank’s balance sheet, and it will allow investors and regulators to evaluate and foster new legislation toward green finance. Recently, in January 2022 the European Banking Authority (EBA) released the final draft of the Implementing Technical Standards (ITS) on Pillar 3 disclosures on ESG risks (Mikkelsen et al., this issue).

The role of central banks

Globally, the Network of Central Banks and Supervisors for Greening the Financial System (NGFS) in December 2017 was aimed at defining and promoting good practices, conducting analysis, fomenting climate risk management in the financial sector, and mobilising funds needed for a transition towards a sustainable economy (NGFS, 2021). In Europe, the national central banks incorporate climate-related questions intro their actions. Furthermore, central banks not belonging to the Eurosystem are even introducing environmental questions into their design of the monetary policy. Central banks have begun integrating sustainable and responsible investment (SRI) principles into their portfolio management (NGFS, 2019, 2020). Outstandingly, the European Central Bank is progressing in evaluating and limiting the potential aftermaths of climate change (ECB, 2021a,b; Reghezza et al., 2021).The European Central Banks is advancing on preparing and executing the ECB Thematic Review on Climate-Related and Environmental (C&E) Risks and the ECB Climate Stress tests that include transition and physical risks in a horizon of 30 years. Accordingly, the SSM included climate-related risks in its 2019 and 2020 roadmaps that draw up supervisory expectations for relevant banks (Alonso and Marqués, 2019; Gonzalez and Núñez, 2020, 2021).

References

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Beyene, W., Delis, M., and Ongena, S. (2021). Disclosure of banks fossil exposures. European Economy – Banks, Regulation and the real Sector, this issue.

Campiglio, E. (2016). Beyond carbon pricing: The role of banking and monetary policies in financing the transition to a low-carbon economy, Ecological Economics 121, 220-230. DOI: https://doi.org/10.1016/j.ecolecon.2015.03.020

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Depledge, J., Saldivia, M., and Peñasco, C. (2022). Glass half full or glass half empty?: The 2021 Glasgow Climate Conference, Climate Policy, 22, 147-157, DOI: 10.1080/14693062.2022.2038482

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European Central Bank (2021a). Climate-related risk and financial stability. ECB/ESRB Project Team on climate risk monitoring. Available at: https://www.ecb.europa.eu/pub/pdf/other/ecb.climateriskfinancialstability202107~87822fae81.en.pdf (Accessed on April 18, 2022).

European Central Bank (2021b). Detailed roadmap of climate change-related actions. Available at: https://www.ecb.europa.eu/press/pr/date/2021/html/ecb.pr210708_1_annex~f84ab35968.en.pdf (Accessed on April 18, 2022).

European Commission (2019). Guidelines on reporting climate-related information. Available at: https://ec.europa.eu/finance/docs/policy/190618-climate-related-information-reporting-guidelines_en.pdf (Accessed on April 18, 2022).

González-Martínez, C.I. (2021). Overview of global and European institutional sustainable finance initiatives. Bank of Spain. Available at: https://www.bde.es/f/webbde/SES/Secciones/Publicaciones/InformesBoletinesRevistas/ArticulosAnaliticos/21/T3/Files/be2103-art30e.pdf (Accessed on April 18, 2022).

González, C. I., and S. Núñez (2020). Cambio climático y sistema financiero: una necesaria mirada al futuro. Papeles de Economía Española No 163, pp. 130-145. Available at: https://www.funcas.es/articulos/cambio-climatico-y-sistema-financiero-una-necesaria-mirada-al-futuro-transicion-hacia-una-economia-baja-en-carbono-en-espana-2019-n-163/ (Accessed on April 18, 2022).

González, C. I., and S. Núñez (2021). Markets, financial institutions and central banks in the face of climate change: challenges and opportunities. Occasional Paper No. 2126. Bank of Spain. Available at: https://www.bde.es/f/webbde/SES/Secciones/Publicaciones/PublicacionesSeriadas/DocumentosOcasionales/21/Files/do2126e.pdf (Accessed on April 18, 2022).

Marullo Reedtz, P. (2021). Financing the environmental transition in Europe. European Economy – Banks, Regulation and the real Sector, this issue.

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Mikkelsen, D., Viscardi, S., Montes, M., and De Amicis, F.P. (2021). Climate change regulation and supervision in Europe and implications for commercial banks. European Economy – Banks, Regulation and the real Sector, this issue.

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NGFS (2021). Annual Report 2020, April.

Reghezza, A., Altunbas, Y., Marques-Ibañez, D., Rodriguez d’Acri, C., and Spaggiari, M. (2021). Do banks fuel climate change? ECB Working Paper Series No. 2550. Available at: https://www.ecb.europa.eu/pub/pdf/scpwps/ecb.wp2550~24c25d5791.en.pdf (Accessed on April 18, 2022).

Science-Based Targets initiative (SBTi). 2021. Financial Sector Science-Based Targets Guidance Pilot Version 1.1, Science-Based Targets initiative (SBTi), Report. Available at: https://sciencebasedtargets.org/resources/files/Financial-Sector-Science-Based-Targets-Guidance-Pilot-Version.pdf (Accessed on April 18, 2022).

World Economic Forum & PwC (2021), Harnessing Technology for the Global Goals: A framework for government action, Accessed on 31st October 2021. Accessed at: https://assets.2030vision.com/files/resources/wef-harnessing-technology-for-the-global-goals-2021.pdf?470b76352b (Accessed on April 18, 2022).

Legislation cited

Commission Delegated Regulation (EU) 2021/2139 of 4 June 2021 supplementing Regulation (EU) 2020/852 of the European Parliament and of the Council by establishing the technical screening criteria for determining the conditions under which an economic activity qualifies as contributing substantially to climate change mitigation or climate change adaptation and for determining whether that economic activity causes no significant harm to any of the other environmental objectives. Available at: http://data.europa.eu/eli/reg_del/2021/2139/oj (Accessed on April 18, 2022).

Commission Delegated Regulation (EU) 2021/2178 of 6 July 2021 supplementing Regulation (EU) 2020/852 of the European Parliament and of the Council by specifying the content and presentation of information to be disclosed by undertakings subject to Articles 19a or 29a of Directive 2013/34/EU concerning environmentally sustainable economic activities, and specifying the methodology to comply with that disclosure obligation. Available at: http://data.europa.eu/eli/reg_del/2021/2178/oj (Accessed on April 18, 2022).

Directive 2014/95/EU of the European Parliament and of the Council of 22 October 2014 amending Directive 2013/34/EU as regards disclosure of non-financial and diversity information by certain large undertakings and groups Text. Available at: https://eur-lex.europa.eu/eli/dir/2014/95/oj (Accessed on April 18, 2022).

European Commission (2019). Communication from the Commission — Guidelines on non-financial reporting: Supplement on reporting climate-related information (2019/C 209/01). Available at: https://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX%3A52019XC0620%2801%29 (Accessed on April 18, 2022).

European Commission (2018). Communication from the European Parliament, the European Council, the Council, the European Central Bank, The European Economic and Social Committee of the Regions. Action Plan: Financing Sustainable Growth (COM/2018/097 final). Available at: https://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX%3A52018DC0097 (Accessed on April 18, 2022).

Regulation (EU) 2020/852 of the European Parliament and of the Council of 18 June 2020 on the establishment of a framework to facilitate sustainable investment, and amending Regulation (EU) 2019/2088 (Text with EEA relevance) Available at: https://eur-lex.europa.eu/eli/reg/2020/852/oj (Accessed on April 18, 2022).

Regulation (EU) 2019/2088 of the European Parliament and of the Council of 27 November 2019 on sustainability‐related disclosures in the financial services sector (PE/87/2019/REV/1). Available at: https://eur-lex.europa.eu/eli/reg/2019/2088/oj (Accessed on April 18, 2022).

Regulation (EU) 2019/2089 of the European Parliament and of the Council of 27 November 2019 amending Regulation (EU) 2016/1011 as regards EU Climate Transition Benchmarks, EU Paris-aligned Benchmarks and sustainability-related disclosures for benchmarks (PE/90/2019/REV/1). Available at: https://eur-lex.europa.eu/eli/reg/2019/2089/oj (Accessed on April 18, 2022).

Regulation (EU) No 575/2013 of the European Parliament and of the Council of 26 June 2013 on prudential requirements for credit institutions and investment firms and amending Regulation (EU) No 648/2012 Text with EEA relevance. Available at: http://data.europa.eu/eli/reg/2013/575/oj (Accessed on April 18, 2022).

A sector-based classification approach

Figure 1. European banks’ exposure towards climate-policy-relevant sectors.

Notes: Own elaboration based on the classification of climate-policy-relevant sectors (CPRS) proposed by Battiston et al. (2017)^[1]Battiston, S., Mandel, A., Monasterolo, Schütze, F and Visentin, G. (2017). A climate stress-test of the financial system. Nature Climate Change 7: 283-288. DOI: https://doi.org/10.1038/nclimate3255 applied to EU banks’ exposures provided by EBA. The CPRS consists of 8 categories, with different incidence in each sector: 1. Fossil fuel, 2. Utility, 3. Energy-intensive, 4. Buildings, 5. Transportation, 6. Agriculture, 7. Finance and 8. Others. Exposures to categories 1 to 6 are defined as those that may be affected by climate transition risks. The total value of expositions is of 2,346.53 billion of euros.

Figure 2: European banks’ exposure towards climate-policy-relevant sectors by category of climate transition risk.

Notes: Based on the classification of climate-policy-relevant sectors (CPRS) proposed by Battiston et al. (2017)^[2]Battiston, S., Mandel, A., Monasterolo, Schütze, F and Visentin, G. (2017). A climate stress-test of the financial system. Nature Climate Change 7: 283-288. DOI: https://doi.org/10.1038/nclimate3255 applied to EU banks’ exposures provided by EBA. The CPRS consists of 8 categories, with different incidence in each sector: 1. Fossil fuel, 2. Utility, 3. Energy-intensive, 4. Buildings, 5. Transportation, 6. Agriculture, 7. Finance and 8. Others. Exposures to categories 1 to 6 are defined as those that may be affected by climate transition risks. The total value of expositions is of 2,346.53 billion of euros.

A greenhouse gas (GHG) emission-based classification approach

Figure 3: European banks’ exposure according to greenhouse gas emission intensity

Notes: Based on EBA. Greenhouse emission intensity buckets applied to EU banks’ exposures provided by EBA. Buckets are defined based on percentiles of the distribution of greenhouse gas, produced by Trucost (S&P Global) https://www.trucost.com (see the table below). The total value of expositions is of 2,346.53 billion of euros.

Figure 4: European banks’ exposure according to greenhouse gas emission intensity and sector.

Notes: Based on EBA.

A scenario analysis

Figure 5: GDP evolution under different climate scenarios.

Notes: Based on the EBA. The two scenarios represent the difference with respect to orderly transition, and they are built using the parameters sourced from the new ECB climate risk stress test framework, which includes the impact of both the transition and physical risks. The ‘disorderly’ scenario is associated with relatively high costs from a delayed/ineffective transition, and the ‘hot house world’ scenario is when no polices are implemented and natural catastrophes might occur.

Figure 6: Changes in firm-level probability of default with respect to the orderly transition scenario (2020 to 2050).

Notes: Based on EBA. Full bars represent the average increase in the probability of default across firms; dotted bars the increase for firms that are more vulnerable to physical risk. The two scenarios represent the difference with respect to orderly transition, and they are built using the parameters sourced from the new ECB climate risk stress test framework, which includes the impact of both the transition and physical risks. The ‘disorderly’ scenario is associated with relatively high costs from a delayed/ineffective transition, and the ‘hot house world’ scenario is when no polices are implemented and natural catastrophes might occur.

Figure 7: Green asset ratio.

Notes: Based on the EBA. The green asset ratio is constructed for each bank by dividing the green exposure – available only for a subset of exposures – by the total original exposure. The green amount is constructed using either bank’s self-reported data or TAC estimates.

1. Introduction

That environmental sustainability should gradually become strictly interrelated to financial activities is a widespread and entirely accepted principle, pursued through financial regulation, supervision, and banks’ and financial institutions’ voluntary actions.

But it is not so obvious why this is the case. If markets were able to internalize environmental costs and risks fully, these should be adequately priced by financial institutions and banks. The allocation of credit and other financial resources would then reflect such costs and risks. And if there were, as there are market failures, these should be addressed by policy instruments targeted explicitly to reducing emissions, like carbon pricing or other fiscal tools, so that financial institutions could then face and respond to adequate pricing signals.

Moreover, by affecting the allocation of assets in terms of their environmental intensity, financial regulations also influence their risk mix. Polluting activities or activities potentially exposed to climate change face physical (environmental damage) and transitional (change in regulation) risks. But green assets are frequently based on new and untested technologies. Hence they are also risky. The ideal mix between these two types of risk should in principle be identified by the objective function of policy makers or social planners, not necessarily by financial regulators.

So, why is there a need for an environmentally-focused action in financial and banking markets? This is one of the two questions addressed in this issue of European Economy. The other one, is how this should and is being done, especially through regulatory and supervisory frameworks, voluntary actions and standards for measuring and disclosing climate and environmental risks.

As for the why, a simple argument is that climate-related risks could impair the ability of central banks to achieve their mandated objectives, for example because climate change and mitigation policies may affect inflation dynamics and also financial stability, as discussed by Campiglio and Lamperti in this issue. Consequently, central banks could directly target green financial instruments in their asset purchase actions.

At the same time, central banks, along with other mandated authorities, could affect the market behaviour of banks and financial institutions through regulatory and supervisory tools. Four other arguments support this type of action.

The first one is that environmentally stringent regulation for financial institutions is less politically costly to be put in place than fiscal instruments affecting the generality of businesses and consumers. Paradoxically, even though nowadays no political party could be elected without a platform explicitly addressing climate change, fiscal tools raising the prices of fossil fuels can give rise to massive political resistance and turmoil, see for example the uprising of the Gilets Jaunes movement in France following a fiscally induced slight increase in fuel prices. At the same time, an effective carbon taxation should be global and fully harmonized through border adjustments. In this respect, a coherent global policy alignment is difficult to implement and faces a lot of resistance, as shown by the recent, pretty generic commitments reached during the United Nation Conference on Climate Change, Cop 26 conference. These policies are necessary of course, but they are not there yet.

Financial institutions are easier to regulate. There is consensus on the need to reduce the riskiness of financial markets in itself, and on the fact that climate change raises high physical risks (e.g. environmental disasters) and transitional risks (e.g. changes in regulation and consequent stranded assets). In that respect, especially banks, have an issue of legacy stranded assets that regulators are bound to face, for example in fossil fuels. Investors are also increasingly sensitive to the pursuance of ESG objectives and are in favour of stringent environmental targets. The risks of investing in green technologies are certainly sizeable and frequently uncertain, but the pressure toward the environmental transition partly reduces the perception of such risks.

A second reason for targeting financial markets is that since fiscal tools are not yet (or are just partially) in place, or in the end they cannot be fully enforced, and consequently market prices do not adequately internalize environmental costs and risks, there is a need for a rapid action, which can more easily be taken by directly targeting financial markets. The mitigation of both physical and transitional risks in asset allocation can more effectively be achieved through financial regulation in the short/medium term. The following section of this editorial discusses this issue at length.

A third one, is that the financial effort required to achieve environmental targets and mitigate climate change is enormous and all resources must be mobilised towards this goal as soon as possible, pressing financial markets in this direction even beyond what would be achievable with mere fiscal incentives.

Fourth and finally, as discussed below, there are failures that cannot be targeted by fiscal instruments and directly pertain to financial markets and interact with pure environmentally induced market failures. For example, credit constraints induced by asymmetric information. Also, De Haas and Beyene et al. in this issue discuss at length how banks generally price environmental risks less than capital markets and how this is also related to the limited perception that depositors, in contrast to direct investors, have on the allocation of banks’ assets. The last part of this editorial will discuss the role of banks vs. capital markets in financing the environmental transition.

As for the how, several contributions in this issue discuss the regulatory and supervisory frameworks adopted or planned (Beyene et al., Mikkelsen et al. and Marullo Reedtz). These, in general, pertain to several domains. First the definition of shared criteria for the measurement and disclosure of the environmental risk, both concerning assets with implicit physical riskiness and those involving transitional costs. Second, the evaluation and inclusion of such risks by financial institutions in their risk appetite frameworks and in supervisory actions and stress tests and the provision by supervisors of clear guidelines. Third, a balanced use of regulatory tools like capital requirements, on the one hand to favour asset allocation towards sustainable investments and, on the other hand, to reduce the risk of rapid divestment from established fuel intensive assets.

The issue focuses especially on the actions of EU institutions, initially triggered by the EU Commission Action Plan on Financing Sustainable Growth in March 2018 and which involves the European Central Bank (ECB), the European Banking Authority (EBA).

Also important are frameworks which imply a voluntary action by financial institutions. In particular, the Task Force on Climate-related Financial Disclosures (TCFD) was established by the Financial Stability Board (FSB) for climate related disclosures and the Net-Zero Banking alliance, which now involves all major financial players. There is an open issue of how far these voluntary arrangements should become compulsory in the longer term.

In what follows, we develop the arguments for why financial regulation should address environmental issues and discuss the different position of banks and capital markets as recipients of such regulatory frameworks.

2. Why financial regulation?

Problems of sustainability of economic decisions are inherent problems of adverse external effects: “the negative effect of production, consumption, or other economic decisions on another person or party, which is not specified as a liability in a contract” (Core, 2017) and therefore is not taken into consideration by a selfish profit or utility maximizing economic agent.

Consider the most debated one: emissions of greenhouse gases causing global warming (Stern and Stern, 2007). Like any other type of pollution, it is a negative externality. Negative externalities have been thoroughly analysed in the economic literature. Two leading solutions have been proposed: limits to production and taxation. Indeed, the most obvious solution in front of a polluter is to force him to stop. But this is an oversimplification because the social costs of completely halting the activities of a polluter can often be higher than the benefits (if Pfizer were marginally polluting to produce vaccines, we would probably be unwilling to force its closure). Welfare maximization requires comparing costs and benefits and set any quantitative limit to production at the level that equates the marginal social costs of production with the marginal benefits. However, this is more easily said than done, especially when producers are in large numbers – coordination on quantity limitations is complex among countries, let aside among single firms – and when the adverse external effects are not instantaneous but delayed in time, as in the case of global warming.

Fixing precise limitations to any activity that generates external effects and imposing them on each economic agent is clearly infeasible. A first option to circumvent this problem is cap and trade policies, i.e. to define a measure of the negative external effect (e.g., tonne of carbon emissions) and price them (see Campiglio and Lamperti in this issue). Once this is done, these policies can go a long way in solving the coordination problems of quantity limitations by allowing firms to trade the right to emit among themselves. Although the decision on how to initially allocate these rights is not obvious, the outcome is efficient, because those firms who incur the lower costs to reduce emissions have the higher incentive to do so. At the same time, the total amount of rights to emit that are granted allows to control the aggregate level of emissions.

Taxation is the alternative to impose quantitative limits, directly or through cap-and-trade policies. Set a Pigouvian tax equal to the marginal external cost – the difference between the (possibly delayed) marginal social cost and the private social cost – and profit maximizing firms will automatically choose the socially optimal production level. Taxation allows to force economic agents to internalize the external effect of their actions, leading to an optimal aggregate level of carbon emissions. According to this view, the optimal strategy to limit greenhouse gas emissions – or any other external effect in production or consumption – is to levy a Pigouvian tax. As such, there is no need to adopt indirect strategies, such as regulations in the financial markets making the cost of funding dependent on how “green” an investment is, so as to “reorient capital flows towards sustainable investment in order to achieve sustainable and inclusive growth” (EU Commission, 2018).

However, there are at least two main problems with this prescription. One is the interaction of the external effects with other features of the economic system, such as imperfections in financial markets. The other is the evaluation of the joint riskiness of both the impact of the negative external effect (e.g., global warming) and the actions addressing it.

The case of imperfections in the financial markets is relatively straightforward. Consider two firms that must decide whether to invest in adopting a greener production technology. To simplify the analysis, assume for the moment that such technology is readily available, and its cost and benefits are known. One incurs lower costs to adapt to the new technology, but due to credit constraints, it faces high borrowing costs and prefers to renounce investing. The other firm has low borrowing costs, but it is also unwilling to invest since it faces high adaptation costs. Taxing carbon emissions would increase the costs for both firms if they did not invest in acquiring the new technology. The firm facing high adaptation costs may be forced to make the investment, despite the higher adaptation costs, while the credit constrained one may still find unprofitable to invest. An alternative policy, introducing incentives to finance green investments, would instead reduce the borrowing costs for the credit constrained firm, making it more likely to invest in green technology. For reasonable ranges of the differences between the costs of adopting the new technology and the borrowing costs for the two firms, it is possible that financial market regulation allows to achieve a lower level of emissions with the same impact on production. Regulations favoring investments in greener productions or technologies may thus be more effective than directly taxing emissions.

The issue of riskiness is two-faceted (on this theme, see also Campiglio and Lamperti in this issue). On the one side, there is a legacy problem: economic activities started when the global warming problem was underestimated (and therefore Pigouvian taxes were not introduced) can suffer significant losses, causing a surge in the riskiness of the existing portfolio of investments. On the other side, there is a perspective problem because the development and adoption of environmentally sustainable technologies require large investments, typically involving a high riskiness of both private and social returns.

The consequences of the permanent increase in average world temperature caused by greenhouse gas emissions are the object of an intense debate among scientists. Their economic effects are also the focus of a growing body of research (Cruz Álvarez and Rossi-Hansberg, 2021). It seems unquestionable that exceptional risks loom ahead.

From a portfolio management perspective, the problem is whether these risks are priced correctly by investors, particularly by financial intermediaries. If global warming led to extreme events causing radical changes in the economic system – from severe weather conditions to substantial relocations of economic activities – the value of assets held by financial intermediaries would collapse. If provisioning to face these risks was insufficient, a financial crisis would likely unfold. As already seen with the global financial crisis of 2007-2008, this may cause monetary policy problems, calling for radical interventions by central banks.

Provisions may be inadequate for two main reasons. First, investors may be unable to collect and process the vast amount of information required for a sound assessment of the risks caused by global warming. A possible solution would then be to elaborate and provide information on the risks caused by global warming to economic activities, to help investors accounting for their effects in their decisions. As argued by Degryse et al. in this issue, this is already happening, at least in part.

Second, the investors and especially financial intermediaries may not have the right incentives to set aside adequate provisions if they believe that the effects of global warming will be so pervasive to require in any case an intervention by public authorities. We can dub this as a “too-pervasive-to-face” problem. The obvious response to such a scenario is to introduce specific regulations of financial markets forcing intermediaries to cover the risks caused by global warming adequately.

In principles, the rationale for such interventions is not to sustain the funding of investments in greener technologies but to cover the risks caused by greenhouse gas emissions. In fact, such risks may even be unrelated to the production of negative external effects, depending only on how much the existing economic activities are exposed to the consequences of such effects. In practice, requiring higher provisions to cover the risks of the activities more severely affected by global warming will also impact on the allocation of portfolios towards greener investments. First, corporations such as airlines both produce negative external effects and are affected by events extreme weather events caused by global warming. Second, the likely introduction of a Pigouvian tax on polluting corporations is itself a risk that regulations will ask to cover, making it less profitable to conduct these economic activities.

The second type of risk is related to developing and adopting “green” technologies, which is an effective alternative to reducing the level of production in industries that negatively impact the environment. The question is how much shall we invest in this endeavour? Welfare maximization requires comparing the cost of developing and adopting these technologies with the benefit that they guarantee in reducing the external costs. However, both costs and the benefits entail significant risks, which are difficult to evaluate, making it difficult to find the funding required for such investments (as in the well-known cases of R&D financing) especially by financiers like banks and traditional investment funds. In complete and perfectly working financial markets, a Pigouvian tax increases the costs of production, providing an incentive to reduce its levels and, therefore, those of greenhouse gas emissions.

However, Pigouvain taxation may be more challenging to organise, and it can create an additional layer of uncertainty, related to its application through time, relative to a financial regulation that favours financing the development and adoption of greener technologies. As discussed in more detail in the next session, differences in risk aversion across financiers can also impact the adoption and development of green technologies.

Banks vs. markets

Finance and investments are necessary ingredients for a swift green transition. This observation naturally begs the question about the most effective ways to finance the investments that the green transition requires. This question has no unique answer, as it depends on the characteristics of the investing firms and the type of investments. The heterogeneity of firms and investments relevant to the green transition explains some of the mixed results identified in the academic literature and discussed in the articles in this issue of European Economy. We identify three critical factors for financing investments in general and the green transition in particular.

First, to understand the role of finance in the green transition, one needs to move away from the ideal world of the Modigliani and Miller theorem, where the source of finance does not matter for firms (value). In a realistic realm, the “pecking order theory” for finance (Myers and Majluf, 1984, for its adverse selection incarnation and Jensen and Meckling, 1976, for the cost-of-agency one) provides a first helpful step in understanding how firms finance different investments. Ample empirical evidence shows that to address issues of asymmetric information and reduce the cost of financing, firms first rely on retained earnings as the cheapest source of funds and then on external finance, first debt and then equity, with increasing financing costs that reflect the higher associated risk for the external parties.

A second relevant element is that the mentioned hierarchy of financing sources adapts to the “financial growth cycle” of the investing firm and its characteristics, such as size and actual and prospective growth. For example, small start-ups with high growth potential and high risk very often rely on venture capital and private equity.

A third key point is the nature of the investments needed for the green transition. Simplifying and relying on the articles on the present issues of the European Economy, we can identify two types of investment: one aiming at drastic innovations and another helping polluting firms start coping with and reducing their emissions using existing technologies. These types of investments are different. The former is much riskier as it aims at delivering new technologies with a long investment span. The latter is less so and could be seen as “retrofitting” or adapting existing production activities with abatement technologies. Also, the output of the former type of investment is typically intangible, such as with intellectual property rights and trade secrets. Instead, that of the latter is incorporated in production assets, such as renewable energy generation. As we further explore below, these critical differences in risk, investment span, and intangibility have material implications for funding different parts of the green transition.

Combining all these factors, the hierarchy in cost of finance, the characteristics of the investing firms, and the types of investments offers a rich picture to understand how and to what extent sustainable finance can contribute to the green transition. In particular, we are interested in understanding which type of finance is better suited to provide funds for the green transition. Given our three key elements, it is clear that the answer to this question depends on the possible matches between the alternatives, in particular (i) the source of funding, e.g., banks or financial markets, (ii) the characteristics of the investing firm, e.g., established firms or high-growth potential start-ups, and (iii) the type of green investment, e.g., new technologies or existing abatement technologies. The possible matches of the factors (i)-(iii) provide 2x2x2 combinations, some of which are more apt to finance the green transition than others.

In particular, in light of these observations, banks may face relevant issues in financing green investments when associated with certain matches combining points (i)-(iii) discussed above. A first specific problem often mentioned is that the green transition operates in a pre-existing environment where banks provide funds to firms, typically relying on debt contracts and associated collaterals. The green transition is intended to shift activities from pre-existing ones to more environmentally friendly ones. This transition tends to reduce the value of pre-existing technologies and associated assets that banks hold in their accounts. Banks may thus prefer not to contribute with their actions that may accelerate this devaluation of assets and collateral related to dirtier technologies. This observation, also discussed in Degryse et al. and De Haas in this Issue of the European Economy is reminiscent of what we have observed with the Non-Performing-Loans(NPL) crisis a few years ago, where banks avoided for quite some time the write-down of bad debts (see the European Economy 2017 issue n. 1). Although unilaterally, the fear of the risk of an adverse market reaction was understandable, collectively, keeping NPL in banks’ balances contributed to a general instability of the whole sector and required prompt policy interventions.

The problem of pre-existing lending to non-clean investments shares some similarities with NPL and some significant differences. In particular, although NPL banks had clear individual incentives to keep inflated asset values, with the green transition, it is difficult to imagine that each bank individually anticipates and fears the devaluation effects in legacy portfolios and hence perceives the risk of the transition of its lending to innovative green technologies. For example, Beyene et al. (2021) show that banks continue to underprice the risk of asset devaluation for traditional investment due to the green transition, which seems odd with a bank’ strategy of limiting entry green innovative firms with credit rationing. Relatedly, other banks’ characteristics contribute to their attitude towards green investment. Since banks tend to have a shorter investment time horizon than equity markets, they consequently tend to care less for possible future devaluation of assets associated with a high-carbon footprint. In this respect, capital markets seem more apt for prompt corrective action incorporating the increasing environmental risks.

Traditional banks also perceive less pressure to adapt to changing needs and preferences of ultimate funders, in their case depositors, as compared with investment funds. Although attention toward cleaner activities and investments is increasing, traditional banks offer a bundle of many different services to depositors, which may dilute the perception by depositors of the greenness of banks’ asset allocation. Relatedly, the actual exposure of banks towards polluting activities and or the fossil fuel sector is not readily available to banks depositors, as emphasized in Beyene, Delis, and Ongena in this Issue of European Economy. On the contrary, when investors patronize investment funds, the link between the funded projects and the investors’ preferences is more direct and visible. Relatedly, the universal-service characteristic of traditional banks makes it more difficult for banks’ management to keep track of the specific technologies adopted by the firms they lend to. This limited knowledge may ultimately weaken banks’ ability to invest in environmental-friendly innovations.

The different technologies relevant to the green transition can more or less fit what banks can effectively offer and handle. Banks can play a significant role in funding transition investments that allow firms to “retrofit” and adapt their production process towards cleaner approaches. In these cases, borrowers’ traditional assets can offer collaterals that banks can rely on for lending. Instead, financing the developments of drastic innovations for new green technologies may be problematic for banks because these types of innovations typically produce intangible outputs such as patents and trade secrets. As with any type of R&D intense investments, when the outcomes of the investments are intangible and thus non-pledgeable, banks can provide limited funding sources, and capital markets are more apt to address these environments. This is also convincingly emphasized by the papers of De Haas and Degryse et al. on this Issue of European Economy, which illustrate that green patented innovations expand faster in countries where equity finance is more prominent compared with bank lending. This observation is particularly relevant for bank-centric Europe that should channel as much as possible equity funding towards environmental innovations, possibly also rebalancing tax biases in favour of equity rather than debt.

How effective are banks dealing with polluting firms? There is some evidence that banks can price loans incorporating environmental impact. Chen et al. (2021) show that firms that emit more pay higher interest rates than banks, primarily when emissions are associated with more risky borrowers and weak governance. However, the question is whether banks are better able than capital markets to price environmental risks correctly. As discussed by De Haas in this Issue of European Economy, access to credit per-se favours investment in cleaner technologies, although the most relevant factor seems instead the quality and attitude of firms’ management towards environmental issues. Moreover, since banks continue to underprice the risk of asset devaluation for traditional investment, firms relying on carbon-heavy technologies are currently moving away from bonds to bank credit, as documented by Beyene et al. (2021b).

Interestingly, both De Haas and Degryse et al. in this Issue of European Economy have shown that the best outcomes from the credit markets obtain when “green-meets-green,” when banks explicitly commit to green lending match with environmental conscious borrowers that effectively disclose their attitude. In these cases, mutual commitment and disclosure on the two sides of the credit market allow for a cheaper lending cost. An immediate policy implication seems thus that of facilitating credible disclosure of the environmental attitude of both sides of the credit market.

Overall, banks’ difficulty in correctly pricing environmental risks combines several elements, as argued above. The articles in this issue of European Economy provide several policy actions that could redress this problem. Essential in this direction will be improving transparency and disclosure requirements about actual exposure to polluting industries and environmental risks. Moving from a voluntary approach (prone to manipulation and cherry-picking, as shown in Bingler et al. 2021) towards mandatory requirements, such as recently announced by New Zealand, the United Kingdom, and Switzerland seems a fundamental step.

3. Conclusions

In principle, Pigouvian taxation could fully internalize environmental costs and risks, making it useless to introduce ad hoc financial regulations (see Cochrane, 2021, for a view along these lines). But to attain a more sustainable equilibrium in the presence of other market failures, policy interventions in the financial markets can be an effective complementary tool to Pigouvian taxation.

Two main types of interventions have been proposed and are being put in place (see, in particular, Marullo Reedtz and Mikklesen et al. in this issue for a comprehensive analysis). First, the provision of rigorous and standardized information to investors, through the definition of criteria for the measurement and disclosure of environmental risks (e.g., the Taxonomy Regulation of the EU, the Sustainable Finance Disclosure Regulation, the Regulation on European green bonds), and the requirement that large public-interest entities publicly report on sustainability issues (e.g., Directive 2014/95/EU). Second, the explicit inclusion of environmental risks in the bank supervisory framework, including capital requirements and stress tests (e.g., EBA’s Implementing Technical Standards on Pillar 3 disclosures on ESG risks), and in central bank’s analyses (e.g., ECB’s Guide on climate-related and environmental risks).

The ample set of policies proposed in the financial sector will be paralleled by more traditional interventions addressing the effect of negative externalities through taxation and quantitative limitations. These will also impact investment returns (see also the discussion in Giovannini and Tamburrini, in this issue). Overall, the impact on the entire financial industry will be pervasive, affecting the choices and performance of banks, investment funds, insurance companies, and retail investors.

A natural set of questions thus arises. What objective function is driving this process? Who has chosen this objective function? Who is controlling that, when enacted simultaneously, the selected policies point in the right direction to achieve the desired goals?

The answer to the first question is apparently easy: the objective of all proposed policies is to internalize the adverse external effects that make individual choices unsustainable. But this goal requires a precise quantification of the social surplus to be maximized, a daunting task in any welfare analysis. In the absence of a unique solution, the objective function to be maximized should be chosen by citizens, following a democratic process. This observation leads to the answer to the second question that elected governments should determine the objective function to be maximized. While it may be largely agreed that the mandate of financial regulatory authorities reflects the government’s will for financial stability and the general working of financial markets, that such a mandate also reflects government choices on environmental issues is not so obvious. This may call for stricter directives from governments to financial authorities on environmental issues so as to enhance their accountability.

The last question has apparently no answer. Different bodies define different sets of rules, often with a large degree of autonomy. But a body or a framework coordinating the different policies and controlling that their decisions are not contrasting is absent. Given the large number of proposed and implemented interventions, the risk of a lack of coordination is substantial. This calls for a coordination table on environmental issues among all interested bodies. This framework should be set at the European level. In addition, given the global scope of environmental issues, it should be organized at the world level (see also Panetta, 2021).

References

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