Authors

Ralph De Haas^[1]Ralph De Haas is the Director of Research at the European Bank for Reconstruction and Development (EBRD) and a part-time Professor of Finance at KU Leuven. He thanks Helena Schweiger, Rada Tomova, … Continue reading

 

1. Introduction

There now exists incontrovertible evidence that human activity, mainly in the form of carbon emissions from industrial production, is warming up the Earth at a rate that has been unprecedented for at least 2000 years (IPCC, 2021). The day-to-day impact of this global warming is becoming increasingly apparent. Extreme temperatures, droughts, floods, and storms are already causing substantial human, ecological, and economic losses.

In the absence of scalable technologies to remove carbon dioxide from the biosphere, mitigating climate change will require a drastic reduction of new carbon emissions. For this reason, and in line with the Paris Climate Agreement, many countries aim to produce zero net greenhouse gas emissions by 2050 at the latest (Millar et al., 2017). This green transition (that is, the road to net zero) will require massive public, private, and public-private investment to develop and then implement cleaner technologies. For example, several governments are currently investing heavily in the development of better lithium-ion batteries and electrolysers to produce hydrogen. At the same time, some private enterprises are investing to make their production methods more energy efficient and to develop new, greener technologies from scratch.

How can the financial system – banks, bonds, as well as public and private equity – facilitate this green transition? A well-established literature has by now shown convincingly that deeper financial systems can foster economic growth (Levine, 1997). An open question is whether the financial sector also influences the ‘greenness’ of economic growth? For example, large-scale investments to invent and then implement green technologies may only be possible if firms can access external finance. Moreover, some sources of finance may be better suited to fund green investment than others. The financial structure of a country may then co-determine how polluting its development path turns out to be.

This article discusses some emerging evidence on the nexus between the financial system, carbon emissions, and economic growth. I will make three main points. First, I will argue that bank credit can help firms to reduce toxic emissions and, to some extent, to improve the energy efficiency of their existing production processes. Second, I will also argue that other organisational constraints, in particular weak firm management, often hold back green investment more than credit constraints do. Third, I will claim that green innovation flourishes more where and when the financial sector is more equity-based and less bank-based.

 

2. Bank lending, toxic emissions, and investments in energy efficiency

Especially during the early stages of the green transition, substantial emission reductions can be achieved by making corporate production (as well as buildings) more energy efficient. In fact, energy efficiency measures could take care of more than 40 percent of the carbon abatement required by 2040 to remain in line with the Paris Agreement (IEA, 2018). This means large-scale industrial investment is needed in cleaner technologies to reduce firms’ carbon footprint. Unfortunately, many firms – especially smaller ones – not only lack internal funding to invest in energy efficiency measures, they often also cannot access bank credit to do so. When credit constraints bite, climate investments may suffer.

An emerging literature shows that when firms get better access to bank loans, the amount of toxic pollution they emit locally often falls. This is presumably because bank credit allows them to invest in, and hence clean up, their production processes. For example Levine, Lin, Wang, and Xi (2018) show how positive credit supply shocks in U.S. counties help to reduce local air pollution. Likewise, Götz (2019) finds that financially constrained firms reduced toxic emissions once their capital cost decreased as a result of the U.S. Maturity Extension Program. Xu and Kim (2022) also find that financial constraints increase firms’ toxic releases. Their evidence suggests that firms trade off pollution abatement costs against potential legal liabilities: the impact of financial constraints on toxic releases is stronger when regulatory enforcement is weaker.

To what extent does access to bank credit not only allow firms to reduce their emission of locally-polluting toxins but also of globally-harmful carbon? Carbon emissions are less visibly harmful at the local level and hence tend to expose firms to less legal risk. Firms may therefore deprioritize investments to reduce such emissions. Recent evidence confirms that while access to bank loans can help firms to limit carbon emissions, credit constraints appear not to be the most binding organizational constraint. For example, a cross-country survey of firm managers shows that despite the potential environmental and efficiency benefits of green investments, many firms refrain from implementing such measures (EBRD, 2019). Close to 60 percent of all interviewed firms see investments in energy efficiency as low priority relative to other investments. A lack of financial resources is the second-most cited reason not to do so, but this answer is only given by about 15 percent of all interviewed managers.

De Haas, Martin, Muûls, and Schweiger (2021) investigate these data in more detail and focus in particular on the relative important of credit constraints versus managerial constraints. They measure each firm’s green management practices by using standardized data on firms’ strategic objectives concerning the environment and climate change. This includes whether there is a manager with an explicit mandate to deal with environmental issues; and how the firm sets and monitors targets (if any) related to energy and water usage, carbon emissions, and other pollutants. In addition, they track which green investments firms made in the recent past. Green investments include machinery and vehicle upgrades; heating, cooling and lighting improvements; the on-site generation of green energy; waste minimization, recycling and waste management; improvements in energy and water management; and measures to control air or other pollution.

Their analysis shows how both credit constraints and green management influence the likelihood of green investments. Credit constraints hinder capital-intensive green investments in particular, such as machinery and vehicle upgrades and improved heating, cooling or lighting. They do not significantly reduce the likelihood of investing in air and other pollution control, potentially due to the “low-hanging fruit” nature of such investments. Firms with good green management practices, on the other hand, are more likely to invest in all types of green investment, with the effect larger for those more typically thought of as green: waste and recycling; energy or water management; air and other pollution controls.

If credit constraints and weak green management reduce firms’ green investments, then this may eventually also hamper decarbonisation efforts. To investigate this, the authors use the European Pollutant Release and Transfer Register (E-PRTR) and focus on a sample of Eastern European countries. The E-PRTR contains data on pollutant emissions of a large number of industrial facilities. Their estimates indicate that, although there was a secular emission reduction during 2007-17, this decline was smaller in localities where banks had to deleverage more after the global financial crisis and where, as a result, more firms were credit constrained.

In sum, a growing body of evidence indicates that when firms have better access to bank credit, they may invest more in cleaner production technologies. This may not only reduce (local) toxic emissions but also (global) carbon emissions. At the same time, for many important energy-efficiency measures that firms can take, access to credit is less of a constraint than the quality of firms’ (green) management. Better-managed firms tend to produce more cleanly, and this is often unrelated to their ability to access bank credit.

 

3. Banks and green innovation

The previous section shows that banks can help, to some extent, with funding investment in tried-and-tested technologies that enhance firms’ energy efficiency. Yet, the steep emission decline needed to achieve net zero by 2050 also requires developing entirely new production technologies. There are at least three reasons to believe that banks may be less willing (or able) to finance R&D into such innovative, greener technologies.

First, many banks tend to be inherently technologically conservative. They fear that funding new (and possibly cleaner) technologies will erode the value of collateral that underpins their existing loans – and which firms used to finance older technologies (Minetti, 2011; Degryse, Roukny, and Tielens, 2020). Second, green innovation (as does any innovation) often involves assets that are intangible and highly firm-specific. Many banks would instead be more comfortable with funding tangible and easily collateralisable assets. Third, banks often have a shorter time horizon (the loan maturity) than equity investors and are hence less interested in whether assets will become less valuable (or even stranded) in the more distant future. For example, banks have only very recently started to price some of the climate risk related to firms with large fossil fuel reserves (Delis, De Greiff, and Ongena, 2018). Even then, many (large) banks continue to provide syndicated loans to fossil fuel firms at spreads that under-price the risk of stranded assets – as compared to bonds issued by those firms. As a result, carbon producers are gradually switching from bond to bank funding (Beyene, Delis, De Greiff, and Ongena, 2021).

 

4. Equity and green innovation

Stock markets may be better suited to fund innovative (and greener) technologies. By their nature, equity contracts are more appropriate to finance projects characterized by both high risks and high potential returns. To the extent that stock prices rationally discount future cash flows of polluting industries, equity investors may, in fact, be more sensitive to the costs and risks of pollution – even if these may only materialize in the future.

A key question is therefore to what extent equity investors take carbon emissions into account when assessing longer-term corporate risk. A growing body of evidence suggests that especially institutional investors are increasingly doing so. Survey evidence by Krueger, Sautner, and Starks (2020) shows that a large proportion of investment managers believe that climate risk is already affecting their portfolio companies. Almost 40 percent of the surveyed investors are therefore aiming to reduce the carbon footprint of their portfolios, including through active engagement with management^[2]This not only holds for investors in developed markets but increasingly also for those investing in emerging market securities (EBRD, 2021).. Such investors may also benefit from pushing companies to reduce carbon emissions because this helps to attract environmentally responsible investment clients (Ceccarelli, Ramelli and Wagner, 2020). Because institutional investors are taking carbon emissions into account when assessing corporate risk, Bolton and Kacperczyk (2021) find that stocks of U.S. firms with higher carbon emissions earn higher returns. Moreover, investors appear to shun carbon-intensive companies, although this effect is limited to direct emissions from production and to the most carbon-intense industries. Recent evidence shows that also private equity providers can help to clean up production processes. Bellon (2020) find that private equity investors have helped to reduce pollution (both CO2 and toxic chemicals) in the oil and gas industry.

 

5. Reducing carbon emissions: Banks versus equity

The above discussion raises the question whether in the aggregate, countries with deeper stock markets relative to banking sectors may in fact follow steeper decarbonisation trajectories. To help answer this question, De Haas and Popov (2021) compare the role of banks and equity markets as potential financiers of green growth. Using a 48-country, 16-industry, 26-year panel data set, they assess the impact of both the size and the structure of the financial system on industries with different levels of carbon intensity. In particular, they distinguish industries on the basis of their inherent, technological propensity to pollute, measured as the carbon dioxide emissions per unit of value added. The authors then investigate two channels through which financial development and financial structure (the relative size of equity markets relative to banking sectors) can affect pollution: between-industry reallocation and within-industry innovation.

Using this empirical framework, the authors derive three findings. First, industries that pollute more for technological reasons, start to emit relatively less carbon dioxide where and when stock markets expand. Second, there are two distinct channels that underpin this result. Most importantly, stock markets facilitate the development of cleaner technologies within polluting industries. Using data on green patents, the authors show that deeper stock markets are associated with more green patenting in carbon-intensive industries. This patenting effect is strongest for inventions to increase the energy efficiency of industrial production. In line with this positive role of stock markets for green innovation, carbon emissions per unit of value added decline relatively more in carbon-intensive sectors when stock markets account for an increasing share of all corporate funding. There is also more tentative evidence for another channel: holding cross-industry differences in technology constant, stock markets appear to gradually reallocate investment towards more carbon-efficient sectors. This is in line with the aforementioned tendency of (some) institutional investors to avoid the most carbon-intensive sectors. Polluting firms in these sectors will then find it more difficult to access external finance, putting them at a competitive disadvantage compared with cleaner companies.

Third, the domestic green benefits of more developed stock markets ‘ at home’ may be offset by more pollution abroad, for instance because equity-funded firms offshore the most carbon-intensive parts of their production to foreign pollution havens. Analysis shows that the reduction in emissions by carbon-intensive sectors due to domestic stock market development is indeed accompanied by an increase in carbon embedded in imports of the same sector. However, the domestic greening effect dominates the pollution outsourcing effect by a factor of ten. This means that stock markets may have a genuine cleansing effect on polluting industries and do not simply help such industries to shift carbon-intensive activities to foreign pollution havens.

 

6. Conclusions

This introductory article has discussed some emerging evidence on the nexus between the financial system, carbon emissions, and economic growth. The evidence shows that while bank lending can help firms to improve the energy efficiency of their current production processes, other organisational constraints, in particular weak firm management, often hold back green investments more than credit constraints. While policy measures that ease access to bank credit may be useful (for example, credit lines that are contingent on the adoption of state-of-the-art energy efficiency technologies) this might just be one element of a broader policy mix to stimulate green investments to boost firms’ energy efficiency.

Governments and development banks may also consider measures to directly help strengthen firms’ green management practices. Advisory services, training programs, and other consultancy related firm-level interventions can help managers to become better “green managers”. Such interventions effectively teach managers how to not leave money at the table by postponing much-needed investments in energy efficiency.

Efforts to increase green investments by reducing credit constraints and by enhancing firms’ managerial skills, will only pay off when the broader institutional framework is supportive. This means in particular that highly distortionary fossil fuel subsidies need to be eradicated. Recent evidence reveals that better-managed firms tend to reduce the fossil-fuel intensity of their production unless they can exploit high fuel subsidies (Schweiger and Stepanov, 2022). Moreover, the introduction of carbon pricing – either through a carbon tax or through a cap-and-trade system – can incentivise firms to stop procrastinating and instead invest in measures to make their production more energy efficient. The role of the financial sector is then a complementary one: it mobilises the funding for investments in energy-efficiency improvements and new technologies as firms respond to prices signals coming from, for example, carbon taxes. It is up to politicians and policy makers to create a policy framework that sets the rights incentives for firms to transition to net zero. The role of the financial system to then help firms to achieve this transition in an efficient way.

A second lesson from recent research is that green innovation tends to flourish more where and when finance is more equity-based and less bank-based. Countries with a bank-based financial system that are on the transition path towards net zero carbon emissions, may therefore also consider measures to stimulate the development of conventional equity markets. This holds especially for middle-income countries where carbon dioxide emissions may have increased more or less linearly during the development process. There, stock markets could play an important role in making future growth greener, in particular by stimulating innovation that leads to cleaner production processes within industries.

One way of doing so, especially in smaller economies, is through the regional integration of smaller equity markets. Such integration could target cross-border market infrastructure (such as links between stock exchanges and securities depositories); the harmonization of regulations; as well as capital market accelerator funds with regional mandates. An example is the successful consolidation of national stock markets in the Baltic region. Nasdaq Baltic operates the stock exchanges in Estonia, Latvia and Lithuania, as well as a common Central Securities Depository. It provides capital market infrastructure across the whole value chain, including listing, trading, and market data, as well as post-trade services including clearing, settlement and safe-keeping of securities. This makes it easier for investors to transact cross-border and, ultimately, for firms to raise equity. Similar efforts are ongoing to integrate several stock exchanges in the Balkans.

Another way to help develop equity markets that can provide firms with the equity needed for green innovation, is by levelling the playing field between the cost of equity and the cost of debt. Countries that want to limit the negative environmental externalities stemming from a financial system that is overly reliant on bank lending (and debt more generally) can reduce tax-code favouritism towards debt (such as the deductibility of interest payments and double taxation of dividends). An example is the notional interest deduction that Belgium introduced in 2006. Similarly, as part of the European Commission’s work on the Capital Markets Union, a common corporate tax base has been proposed to address the current debt bias in corporate taxation. A so-called Allowance for Growth and Investment will give firms equivalent tax benefits for equity and debt.

In parallel, countries can take measures to counterbalance the tendency of banking sectors to (continue to) finance relatively “dirty” industries. Examples include the green credit guidelines and resolutions that China and Brazil introduced in 2012 and 2014, respectively, to encourage banks to improve their environmental and social performance and to lend more to firms that are part of the low-carbon economy. From an industry perspective, adherence to the so-called Carbon Principles, Climate Principles, Equator Principles, UN Principles for Responsible Banking, as well as the Collective Commitment to Climate Action should also contribute to a greening of bank lending. Strict adherence to these principles can potentially make governmental climate change policies more effective by accelerating capital reallocation and investment towards low-carbon technologies.

To incentivize and enable banks to adhere to these Principles in a meaningful way, supervisory climate stress tests, such as currently being undertaken by the European Central Bank, can be useful. Moreover, a growing number of banking supervisors – as part of developing a Pillar 3 framework on ESG risks and in line with the Financial Stability Board’s Task Force on Climate-related Financial Disclosures – is moving towards mandatory disclosure of climate-related financial risks. The meaningful disclosure of climate risks will allow depositors, investors, and other stakeholders to make more informed decisions and hence to enhance market discipline. Relatedly, the meaningful disclosure of climate risks by companies is a precondition for banks and other providers of capital to understand and manage climate-related risks. This work is likely to be facilitated by that of recently announced International Sustainability Standards Board, which aims to create a global, comparable set of sustainability standards.

Lastly, the so-called Net-Zero Banking Alliance (NZBA), a United Nations initiative, brings together banks that are committed to align their portfolios with net-zero emissions by 2050. A useful aspect of this alliance is that it helps banks to set (and publicly commit to) an intermediate target for 2030 or sooner, thereby accelerating their decarbonisation strategies and making them more credible. Even then, voluntary commitments may not suffice, as evidenced by the fact that many global banks that signed up to the NZBA and similar initiatives continue to finance fossil-fuel extraction at scale. Banks looking for more credible decarbonisation strategies may choose to have their strategies validated by the Science Based Targets initiative (SBTi), an independent body that assesses whether banks strategies are aligned with the Paris goal of limiting global warming to 2° C.

 

References

Bellon, A. (2020). Does Private Equity Ownership Make Firms Cleaner? The Role of Environmental Liability Risks. Mimeo.

Bolton, P., and Kacperczyk, M.T. (2021). Do Investors Care about Carbon Risk? Journal of Financial Economics, 142(2): 517-549.

Ceccarelli, M., Ramelli, S., and Wagner, A. (2020). Low-Carbon Mutual Funds. mimeo.

Degryse, H., Roukny, T., and Tielens, J. (2020). Banking Barriers to the Green Economy. Working Paper 391, National Bank of Belgium, Brussels.

De Haas, R., Martin, R., Muûls, M., and Schweiger, H. (2021). Managerial and Financial Barriers to the Green Transition. CEPR Discussion Paper No. 15886, Centre for Economic Policy Research, London.

De Haas, R., and Popov, A. (2021). Finance and Green Growth. CEPR Discussion Paper No. 14012, Center for Economic Policy Research, London.

Delis, M.D., de Greiff, K., and Ongena, S. (2018). Being Stranded on the Carbon Bubble? Climate Policy Risk and the Pricing of Bank Loans. CEPR Discussion Paper No. 12928.

EBRD (2019). Transition Report 2019-20: Better Governance, Better Economies. European Bank for Reconstruction and Development, London.

EBRD (2021). The Investor Base of Securities Markets in the EBRD Regions, 3rd Edition, April, European Bank for Reconstruction and Development, London.

IEA (2018). Energy Efficiency 2018. Analysis and Outlooks to 2040. International Energy Agency (IEA), Paris.

IPCC (2021). Climate Change 2021: The Physical Science Basis. Contribution of Working Group I to the Sixth Assessment Report of the Intergovernmental Panel on Climate Change (IPCC), Cambridge University Press.

Götz, M. (2019). Financing Conditions and Toxic Emissions. SAFE Working Paper No. 254, Frankfurt.

Krueger, P., Sautner, Z., and Starks, L.T. (2020). The Importance of Climate Risks for Institutional Investors. Review of Financial Studies, 33(3): 1067-1111.

Levine, R. (1997). Financial Development and Economic Growth: Views and Agenda, Journal of Economic Literature, 35(2): 688-726.

Levine, R., Lin, C., Wang, Z., and Xie, W. (2018). Bank Liquidity, Credit Supply, and the Environment. NBER Discussion Paper No. 24375, National Bureau of Economic Research.

Millar, R.J., Fuglestvedt, J.S., and P. Friedlingstein et al. (2017). Emission Budgets and Pathways Consistent with Limiting Warming to 1.5°C. Nature Geosience, 10: 741-747.

Minetti, R. (2011). Informed Finance and Technological Conservatism. Review of Finance, 15(3): 633-692.

Schweiger, H., and Stepanov, A. (2022). When Good Managers Face Bad Incentives: Management Quality and Fuel Intensity in the Presence of Price Distortions. Energy Policy, forthcoming.

Xu, Q., and Kim, T. (2022). Financial Constraints and Corporate Environmental Policies. Review of Financial Studies, 35(2): 576-635.

Authors

Paolo Marullo Reedtz^[1]Member of the Platform on Sustainable Finance.

 

The European Union’s commitment to a rapid and concrete transition towards environmental sustainability objectives has become progressively more pervasive and systematic in recent years after the ratification, in October 2016, of the Paris Agreement setting the goal to hold the average global temperature increase well below 2°C compared to pre-industrial levels and to pursue efforts to limit the increase to 1.5°C.

Political and legislative initiatives have touched highly significant moments with: i) the Communication on the European Green Deal officially adopted by the European Commission (EC) in December 2019 for a growth strategy consistent with the commitment to achieve no net emissions of greenhouse gas (GHG) in 2050^[2]Communication from the Commission to the European Parliament, the European Council, the Council, the European Economic and Social Committee and the Committee of the Regions, The European Green Deal, … Continue reading, ii) the political agreement reached by the European Council in November 2020 on a comprehensive financial package of €1,824.3 billion in which 30% of the total funds are earmarked for the fight against climate change; iii) the European Climate Law of 30 June 2021^[3]Regulation (EU) 2021/1119 of the European Parliament and of the Council of 30 June 2021. which has changed to commitment to reach climate neutrality into legally binding obligation for the EU Institutions and Member States and has set the intermediate target of reducing net greenhouse gas emissions by at least 55% by 2030, compared to 1990 levels.

However, the amount of public funds allocated with such a huge financial package is not sufficient to achieve the objectives set by the EU Green Deal^[4]According to the Commission’s assessments, Europe will need an estimated EUR 350 billion in additional investment per year over this decade to meet its 2030 emissions-reduction target in energy … Continue reading. As a consequence, a substantial share of the financing flows has to come from the private sector. This, in turn, makes it essential to introduce incisive reforms in order to enrich the endowment of the financial markets in terms of information, instruments, products, and services, in order to allow private investors to rapidly reorient capital flows towards sustainable investments.

This article intends to review the legislative reforms launched in recent years with this aim and provide some tentative indications on upcoming needs.

 

1. The Action Plan for Financing Sustainable Growth

The overall strategy for boosting the role of private finance in pursuing environmental and social goals (The Action Plan for Financing Sustainable Growth) was presented by the EC in March 2018^[5]Communication from the Commission to the European Parliament, the European Council, the Council, the European Central Bank, the European Economic and Social Committee and the Committee of the … Continue reading. A set of additional complementary initiatives, the so-called Renewed Sustainable Finance Strategy (RSFS), was then announced in July 2021^[6]Communication from the Commission to the European Parliament, the European Council, the Council, the European Central Bank, the European Economic and Social Committee and the Committee of the … Continue reading.

Consistently with the analytical issues, the set of initiatives contained in the Action Plan aim to: 1) reorient capital flows towards sustainable investment in order to achieve sustainable and inclusive growth; 2) manage financial risks stemming from climate change, resource depletion, environmental degradation and social issues; 3) foster transparency on environmental factors in corporate communication and public information provided by financial operators and favour long-termism in financial and economic activity.

Stakeholders need to make investment choices aligned with their appetite for sustainability and to assess the risks that environmental factors pose to the value of their investments. Thus, the Action Plan can be represented as a set of three lines of work centered on a European classification system of sustainable activities (the Taxonomy): (i) initiatives aimed at completing the financial market infrastructure in support of large investors; (ii) reforms aiming at expanding the set of investment opportunities in sustainable activities for retail investors; (iii) potential changes to the financial regulatory framework to increase the consideration of environmental factors in investment decisions and risk management processes of banks and institutional investors.

 

2. The EU Taxonomy of sustainable economic activities

The Taxonomy Regulation^[7]Regulation (EU) 2020/852 of 18 June 2020. (TR) serves as the cornerstone of the entire Action Plan: establishing a classification system for economic activities that can be univocally defined environmentally “sustainable” provides companies and issuers of securities with a commonly accepted benchmark to demonstrate their current and future commitment in sustainable activities and to qualify the request for funds. Moreover, the Taxonomy makes it possible for financial market participants (FMPs) and retail savers to seize eco-sustainable investment opportunities without the risk of incurring into greenwashing.

The TR considers six environmental objectives; (a) climate change mitigation; (b) climate change adaptation; (c) the sustainable use and protection of water and marine resources; (d) the transition to a circular economy; (e) pollution prevention and control; (f) the protection and restoration of biodiversity and ecosystems.

An economic activity can be defined sustainable if it: 1) contributes substantially to one or more of the six environmental objectives; 2) does not significantly harm any of the remaining environmental objectives; 3) is carried out in compliance with the minimum safeguards^[8]As developed in the OECD Guidelines for Multinational Enterprises and the UN Guiding Principles on Business and Human Rights. 4) complies with technical screening criteria (TSC) established by delegated acts adopted by the EC.

The TSC are meant to identify the conditions that determine both the substantial contribution (SC) and a significant harm (SH) to each environmental objective: they must be based on scientific evidence and the precautionary principle embedded into the European legislation; they must be quantitative and contain thresholds to the extent possible, and otherwise be qualitative; they have to be periodically reviewed to remain aligned with scientific and technological developments^[9]A first set of TSC has already entered into force: for a large number of economic activities, the conditions under which it can be said that a significant contribution to one of the two climate … Continue reading.

In addition to economic activities that directly make a substantial contribution to one or more of the environmental objectives without causing significant harm to any of the other objectives, the Taxonomy qualifies as sustainable: a) the activities (transitional activities) which cannot yet be replaced by technologically and economically feasible low-carbon alternatives but support the transition to a climate-neutral economy by presenting the greenhouse gas emissions levels (GHG) corresponding to the best performance in the sector or industry, and; b) those (enabling activities) which do not substantially contribute to climate change mitigation through their own performance but by directly enabling other activities to make a substantial contribution to one or more of the six environmental objectives.

Parallel to the completion of the overall design of the Taxonomy with the definition of TSC, works are being carried out for the possible extension of its scope of application. Regulation (EU) 2020/852 itself requires the Commission to publish a report describing the provisions that would be required to extend the classification system to cover economic activities that do not have a significant impact on environmental sustainability (NSI) and economic activities that significantly harm environmental sustainability and to broaden the range of sustainability objectives to social objectives.

At the same time, the Regulation established a Platform on Sustainable Finance^[10]The Platform, which constitutes an independent Expert Group, includes representatives of European institutions, member chosen in the industrial and financial sectors, experts representing civil … Continue reading with the mandate to provide advice to the Commission on the suitability and feasibility of these amendments; the TSC and the possible need to develop, update or revise those criteria and on their usability; the evaluation and development of sustainable finance policies.

 

3. Initiatives aiming at supporting large investors

3.1. Corporate Communication

At the entry into force of the TR, the main source of company information on environmental factors was Directive 2014/95/EU (the Non-Financial Reporting Directive, NFRD) requiring large public-interest entities^[11]Public-interest entities in the EU include entities governed by the law of a Member State whose transferable securities are admitted to trading on a regulated market of any Member State, credit … Continue reading with an average number of employees in excess of 500 to report both on how sustainability issues affect their performance, position and development (the ‘outside-in’ perspective), and on their impact on people and the environment (the ‘inside-out’ perspective) (double materiality approach). According to the TR (Art. 8) the entities that are in the scope of the NFDR have to disclose, in addition, information on how and to what extent their activities are Taxonomy compliant.

The key performance indicators to be disclosed by non-financial undertakings are specified directly in the Regulation: the proportion of their turnover derived from products or services associated with sustainable activities and the proportion of their capital expenditure and the proportion of their operating expenditure related to assets or processes associated with sustainable economic activities. The content and format of the disclosure obligations of financial undertakings have been defined by the Commission Delegated Regulation (EU) 2021/2178 of 6 July 2021, which applies from 1 January 2022. As for credit institutions, the key performance indicators show the share of the business related to Taxonomy-aligned economic activities separately for on-balance sheet assets (the green asset ratio for loans and advances/debt securities/ equity instruments); off-balace sheet items arising from holding assets under management and providing financial guarantees; fees and commission income derived from commercial services and activities; trading activity.

In the Action Plan, the EC announced forthcoming measures to meet the need to improve the quality of corporate communication on environmental issues. As also emerged from a public consultation launched in February 2020^[12]European Commission (2020)., the information provided was considered lacking in terms of comparability, reliability and effective relevance; the plurality of possible communication channels hindered the joint finding and use of information released by different companies which, in addition, were rarely available in a machine-readable digital format; the limited number of reporting entities severely limited the scope of assessments by investors and other stakeholders.

The Proposal for a new Corporate Sustainability Reporting Directive (CSRD) published in April 2021 contains important changes: a) it extends the scope of the reporting requirements to all large companies and listed companies (from approximately 11,700 to nearly 50,000); b) it requires the audit of reported sustainability information; c) it specifies in more detail the information that companies should provide according to sustainability reporting standards to be developed by the European Financial Reporting Advisory Group (EFRAG) and consequently adopted by the EC; d) it requires that all information is published as part of companies’ management reports, and disclosed in a digital, machine-readable format in order to be included in the European Single Access Point. According to a proportionate approach, no mandatory reporting requirements are imposed on small and medium-sized enterprises (SMEs), except those listed on EU regulated markets^[13]Moreover, listed micro-companies are exempted from mandatory reporting obligations.. Moreover, the EC will adopt standards for large companies and separate, proportionate standards for listed SMEs to be used on a mandatory basis, while non-listed SMEs will decide whether to use them on a voluntary basis.

 

3.2. EU Climate Benchmarks

In the Action Plan, the EC noted the increasing demand for benchmarks suitable for measuring the environmental performance of financial portfolios. In response, the market was offering a plethora of indices which, despite differences in objectives and methodologies, were proposed as low-carbon.

In order to increase the comparability between benchmarks, provide a tool to support climate-focused investments, and increase transparency with respect to the impacts of investments, Regulation (EU) 2019/2089 of 27 November 2019 introduced two types of climate benchmarks: the EU Climate Transition Benchmarks (EU CTB) and the EU Paris-Aligned Benchmarks (EU PAB) and established ESG disclosure requirements applicable to all registered benchmark administrators^[14]ESG disclosure requirements are applicable to all investment benchmarks, with the exception of currency and interest rate indices whose underlying assets don’t have any impact on climate change. … Continue reading.

The two new climate benchmarks incorporate specific targets of reducing greenhouse gas emissions, through the choice and weighting of the underlying assets. They entail different ambition levels: a) the EU PABs have stricter demands, including alignment with the Paris Climate Agreement global warming targets and a 50% lower weighted average GHG intensity than the investable universe, and they are designed for institutions actively pursuing the Paris climate goals; b) the EU CTBs require a 30% lower GHG intensity than the investable universe and are primarily intended for diversification strategies with a focus on climate risk mitigation.

For EU PABs and EUCTBs, benchmark administrators are requested to disclose in their benchmark statements details on whether or not and to what extent a degree of overall alignment with the target of reducing GHG emissions or the attainment of the objectives of the Paris Agreement is ensured and to publish the methodology used for the calculation of those benchmarks.

 

3.3. EU Green Bond Standard

At the time the Action Plan was prepared, the green bond market, although rapidly expanding, was not considered large enough to support the transition towards climate mitigation targets and appeared to be affected by some barriers^[15]EU Technical Expert Group on Sustainable Finance (June 2019).: 1) uncertainty about the actual quality of the financed projects in terms of environmental performance; 2) high operating costs associated with the procedures necessary for the issue; 3) reputational risks for the issuers if the market doesn’t consider the project to be financed sufficiently green or if the project fails to achieve the announced environmental objectives.

Building on such analysis, the EC has developed a Proposal for an EU Regulation on European green bonds which was presented on 6 July 2021 defining a robust EU Green Bond Standard (EUGBS) to be made available to issuers for voluntary adoption.

The overall proposed discipline comprises four components: (1) Taxonomy-alignment of use of proceeds: the proceeds shall be exclusively and fully allocated to economic activities that meet the taxonomy requirements currently or within a defined period of time^[16]The period shall not exceed five years from bond issuance, unless a longer period of up to ten years is justified by the specific and documented features of the economic activities concerned, as … Continue reading; (2) well defined issuing procedures: the issuers are required to publish a European green bond factsheet showing the intention to adhere to the EU GBS Regulation, information on how the bond aligns with the broader environmental strategy of the issuing entity, the environmental objectives pursued by the bond, a description of the processes by which the issuer will determine how projects align with the taxonomy requirements, the time schedule along which the proceeds will be allocated to the projects; (3) a reporting regime articulated into an ‘allocation report’ to be drawn up every year by the issuers demonstrating that the proceeds of the European green bonds have been actually allocated in accordance the Regulation and an ‘impact report’ on the environmental impact of the use of the bond proceeds to be published after the full allocation of the proceeds of the green bonds and at least once during the lifetime of the bond; (4) an external review requirement: all pre-issuance and post-issuance public information has to be ‘certified’ by external reviewers registered with ESMA and complying with a series of requirements regarding their governance, prevention of conflicts of interest, organisational structure, sound and prudent management, assessment methodologies and knowledge and experience of the analysts; (5) a supervisory system centered on ESMA, for which the supervisory and investigatory powers of the competent authorities and administrative sanctions and other administrative measures are provided in detail.

 

3.4. Sustainability in credit rating and ESG scoring services

The Action Plan noted the proliferation of services for the evaluation of companies’ ESG performance. Lack of transparency on data sources and methodologies made it extremely difficult to assess which of the scores was more reliable^[17]Doubts arised from the low degree of correlation between the ESG scores available to investors, ranging from 0.4 to 0.7, vis a vis the correlation between credit ratings (above 0.9), see Berg F. et … Continue reading. On the other hand, there was no clarity on the extent to which sustainability factors were included in credit ratings and according to which methodologies.

Consequently, the EC made a commitment to carry out a comprehensive study on sustainability ratings and research and invited ESMA to assess the current practice within the credit rating market concerning sustainability considerations. ESMA was also invited to include environmental and social sustainability information in its guidelines on disclosure for credit rating agencies (CRA), and to consider additional guidelines or measures, if needed.

In the Technical Advice published on 18 July 2019 ESMA confirmed that ESG factors are included in the creditworthiness assessments with heterogeneous methodologies but expressed the opinion that credit ratings should remain distinct from sustainability assessments. Updating disclosure requirements on how ESG factors are treated by credit rating agencies (CRA) were considered preferable to mandating the consideration of sustainability characteristics in CRA’s credit assessments. In this vein, ESMA published new guidelines requiring greater transparency around whether and why ESG factors are a key driver of the credit rating action^[18]See ESMA (2019)... As shown in a recent study^[19]See Amzallag et al. (2022)., although the overall level of disclosure has increased, significant divergencies remain in CRAs’ disclosures even for rated entities that are highly exposed to ESG factors. As a consequence, ESMA expresses the commitment to continue analysing the underlying drivers of the observed heterogeneity and to consider the appropriate supervision and policy tools for further transparency.

As regards the ESG rating sector, in January 2021 ESMA signalled the need to ensure the quality and reliability of assessments and stem the risk of greenwashing^[20]See ESMA (2021).. A common definition of ESG ratings was considered a necessary prerequisite for a regulatory and supervisory framework including an authorization and registration discipline and minimum subjective requirements in terms of organization, transparency and prevention of conflict of interest that can be suitable for both large multi-national providers and smaller entities. ESMA declared to be ready to support possible future supervisory responsibilities in this area. Moreover, in order to gather information on the market structure for ESG rating providers in the EU, on 3 February 2022 ESMA launched a call for evidence addressed to ESG rating providers and users, and to entities subject to ESG assessments.

 

4. Initiatives aiming at supporting retail investors

4.1. Sustainability-related disclosures in the financial services sector

In the Action Plan it was noted that, although investors and asset managers are required to act in the best interest of the end-investors, they do not systemically consider sustainability factors and risks in their investment/advice decisions and disclosure processes.

In order to reduce information asymmetries in principal-agent relationships with regard to environmental factors and risks and to the impact of investment decisions on sustainability factors, Regulation (EU) 2019/2088 of 27 November 2019 (Sustainable Finance Disclosure Regulation, SFDR) introduced new requirements for financial product manufacturers and financial advisers both at entity level and at product level.

At the entity level, FMPs and financial advisers are required to disclose on their websites information on their policies to consider principal adverse impacts (PAIs) of investment decisions (made or suggested), for which the definition of content, methodologies and presentation is entrusted to the ESAs. In pre-contractual disclosures, FMPs/financial advisers must include descriptions of how sustainability risks are integrated into the investment decisions (made or suggested) and of the likely impacts of sustainability risks on the returns of the financial products they make available/advise on.

At product level, FMPs are required to explain whether and how a financial product considers PAIs on sustainability factors. For financial product promoting environmental and/or social characteristics, pre-contractual disclosure must include information on how those characteristics are met and, if an index has been designated as a reference benchmark, information on whether and how this index is consistent with those characteristics. Where a financial product has sustainable investment as its objective and an index has been designated as a reference benchmark, pre-contractual disclosure disclosed must contain information on how the designated index is aligned with that objective and an explanation as to why and how the designated index aligned with that objective differs from a broad market index. For both the promotion of environmental or social characteristics and sustainable investments, FMPs are required to publish on their websites a description of the environmental or social characteristics or the sustainable investment objective and information on the methodologies used to assess, measure and monitor the environmental or social characteristics or the impact of the sustainable investments selected for the financial product.

 

4.2. Sustainability considerations in financial advice

As observed in the Action Plan, investors’ preferences regarding sustainability are often not sufficiently taken into account by investment firms and insurance distributors in the phase in which they assess clients’ investment objectives and risk tolerance in order to recommend suitable financial instruments or insurance products. For this reason, changes to the Markets in Financial Instruments Directive (MiFID II) and to the Insurance Distribution Directive (IDD) delegated acts were announced.

In fact, on 21 April 2021 the EC amended existing delegated acts by introducing the assessment of client’s sustainability preferences in the suitability assessment.

Insurance and investment advisers are required to obtain information not only about the client’s financial expertise and ability to bear losses but also about their sustainability preferences in order to assess the range of financial instruments and products to recommend. To prevent the risk of greenwashing, it is established that, in order to be recommended to customers as responding to any expressed sustainability preference, any financial instrument or insurance-based investment product a) must finance Taxonomy-aligned economic activities for a minimum proportion determined by the client; b) must finance sustainable investments as defined in the SFRD for a minimum proportion determined by the client; c) must consider PAIs on sustainability factors as defined in the SFRD where qualitative or quantitative elements demonstrating that consideration are determined by the client.

4.3. The EU Ecolabel for retail financial products

In order to facilitate retail investors to express their preferences in terms of sustainability and for an easier access to sustainable financial products, the Action Plan considered the potential merit of a voluntary labelling scheme for financial products unequivocally connected with sustainable activities.

Work carried out at the Joint Research Center of the EC has resulted in a set of proposals that have been refined over time. According to the document released in March 2021^[21]See Konstantas et al. (2021)., financial products can be labelled as sustainable if, among other requirements, they: invest in Taxonomy-aligned activities to an extent not lower than a certain threshold; do not finance companies that derive more than 5 percent of their turnover from a specific list of activities considered harmful to environmental objectives; do not finance companies that do not meet certain criteria relating to social aspects or are not in line with good corporate governance practices; are offered by fund managers engaging with financed entities in order to obtain improvements in their environmental performance. The preparation of a specific European regulation is currently underway.

 

5. Sustainability in the prudential framework of credit institutions

At the time of the Action Plan, alarmed warnings had already been issued for the exposure of the financial system to the risks associated with climate change. Mark Carney had evoked the Tragedy of the horizon and had introduced the classification of climate risks (physical, transition, and liability risks) which has now become the common point of reference^[22]See Carney (2015)...

The Action Plan showed concern that environmental risks were not adequately considered in business strategies and risk management systems of credit institutions and insurance companies and that capital requirements should better reflect the risk of sustainable assets. As a consequence, EIOPA and EBA were mandated to assess the potential inclusion of ESG risks in the prudential regulatory frameworks and to elaborate on how the institutions could better identify, assess and manage ESG risks^[23]For EIOPA the mandate was given in the Action Plan; for EBA the mandate regarding credit institutions and investment firms (the institutions) was contained in Article 98(8) of Directive 2013/36/EU … Continue reading.

In compliance with the mandate, in June 2021 EBA Report issued a report^[24]See EBA (2021). containing an overview of bank current practices and a set of recommendations aimed at integrating ESG risks^[25]Defined as as risks that stem from the current or prospective impacts of ESG factors on bank counterparties or invested assets and fall into the traditional categories of financial risks (credit … Continue reading into the definition of bank business strategies, internal governance structures, and risk management systems^[26]On the same issues, in November 2021 the Basel Committee for Banking Supervision published a Consultation Document on Principles for the effective management and supervision of climate-related … Continue reading. As for business strategies, EBA pointed out the need of extending the time horizon for strategic planning (to at least 10 years) consistently with the materialisation horizon of ESG risks and of testing their outcomes under different scenarios. Setting, disclosing and implementing ESG risk-related strategic objectives and/or limits was also recommended, as well as engaging with borrowers and investee companies, if appropriate by referring to taxonomies. Regarding governance arrangements, special attention was given to the role of the management body in establishing an ESG risk culture, setting the risk appetite, ensuring that tasks and roles relating to ESG risks are clearly and effectively allocated between internal structures. For risk management, the focus was on the operational and methodological challenges connected with the lack of data to identify and measure ESG risks, the difficulty of developing ESG risk metrics, in-house scoring system and risk models, scenario analysis and stress-testing tools, also due to the fact that a much longer time horizon becomes relevant than that currently considered. Despite these difficulties, credit institutions were recommended to include ESG risks in their risk appetite framework and describe their risk tolerance along with the resulting thresholds and limits in their ICCAP and ILAAP; collect information on the exposure of their counterparties to ESG risks, especially in the loan origination phase.

Integrating ESG risks into the Supervisory Review and Evaluation Process (SREP) performed by competent authorities under Pillar 2 of the prudential regulation encounters difficulties that are very similar to those experienced by credit institutions. Specific attention should be given to how ESG factors affect the business environment and the viability and sustainability of the business model and on whether institutions sufficiently test the resilience of their business model against the time horizon of the relevant public policies or broader transition trends. Scenario analysis and stress testing should be used to assess the long-term resilience of institutions and their vulnerabilities in terms of capital, liquidity, and funding.

The EBA recommendations to both credit institutions and supervisors have been widely taken into account by the EC in developing the Banking Package presented on 27 October 2021, that finalises the implementation of the Basel III agreement in the EU. New, formal requirements for institutions to systematically identify, measure and manage ESG risks are introduced and regular climate stress testing activity has to be implemented by both banks and supervisors. Pillar 3 disclosure requirements for ESG risks are expanded from only applying to large, listed institutions to all in the scope of the CRR, in such a way to respect the proportionality principle^[27]On 24 January 2022, EBA published draft implementing technical standards (ITS) on Pillar 3 disclosures on ESG risks, putting forward comparable disclosures to show how climate change may exacerbate … Continue reading.

In redefining and completing the prudential framework of banking activity, the EC took the opportunity to return to an issue already touched upon in the Action Plan and never abandoned: the potential calibration of capital requirements that could be justified from an ESG risk perspective. In the Proposal for amending CCR, EBA is mandated to deliver a report on the prudential treatment of bank exposures by 2023^[28]In parallel, in the framework of a comprehensive review of EU insurance rules (“Solvency II”) on 23 September 2021, EIOPA has been mandated to explore by 2023 a dedicated prudential treatment of … Continue reading.

While in the Action Plan the attention seemed to be put on sustainable activities deserving a supporting factor in relation to their lower exposure to ESG risks^[29]“the Commission will assess whether more appropriate capital requirements could be adopted to better reflect the risk of sustainable assets held by banks and insurance companies. Such a supporting … Continue reading, in the Proposal for amending CCR the assessment EBA is called upon to carry out regards “a targeted calibration of a risk weights for items associated with particularly high exposure to climate risk, including assets or activities in the fossil fuel sector and in high climate impact sectors”. In any case, the EC’s attitude seems to mainly reflect the objective of channeling funding flows towards environmental objectives, which could find support in the expected lower exposure of sustainable activities to environmental risks and in some empirical analyses showing that companies that focus on sustainability benefit from higher cash flows, greater earnings stability, better credit ratings, and lower market premia^[30]Analytical arguments and empirical analyses are contained in Carney, M (2019a,b) and in Alessi et al. (2020)..

However, as emerged from a survey conducted by the Basel Committee in 2020^[31]See Basel Committee on Banking Supervision (2020)., most members have not yet factored the mitigation of climate-related financial risks into their prudential capital framework. A series of considerations probably explain the reluctance of regulatory authorities and supervisors to adopt an ‘economic policy approach’. As for the green supporting factor, introducing a new source of risk is hardly consistent with reducing the capital charge, which for assets financing sustainable activities could at most remain unchanged. Moreover, there is no certainty that an advantage in terms of capital requirements would translate into an increase in financing sustainable activities; the experience with the SME adjustment factor is not conclusive. A brown penalizing factor would align bank capital to higher transition risk of certain activities but could hit non financial companies which need funds to improve their ESG performance and amplify the risks in the long period. But, more importantly, in order to fully integrate ESG risks in banks’ balance sheet, it is essential to accurately measure the ESG risks associated to each asset, not only to the green or the brown. However, at the present time measuring risk differentials stemming from a different impact of ESG factors on the various assets encounters the already mentioned difficulties in terms of data, risk metrics and forward-looking assessment models^[32]The debate between a risk approach and an economic policy approach is carefully reviewed in Berenguer et al. (2020)..

 

6. An Extended Taxonomy for a strenghtened Action Plan?

As already mentioned, Art. 26 of the TR provides for the possibility of extending the scope to cover activities that do not have a significant impact on environmental sustainability and economic activities that significantly harm environmental sustainability and the newly created Platform for Sustainable Finance (Art. 20) has been mandated to advise the Commission on the possible need to amend the TR. The final Report of the Platform, published on 28 March 2022, contains both an analysis of the pros and cons of an Extended Taxonomy (ET) and a set of recommendations for a smooth and effective introduction of the two new categories activities in the TR^[33]See Platform on Sustainable Finance (2021)..

The main pro of an ET is that, once the TSC are completely defined, it would make it possible to classify all the economic activities carried out by a company, by a productive sector, by an entire economy with respect to environmental objectives and, consequently, the environmental performance of the assets in financial portfolios. At the same time, this would avoid a recurrent binary misinterpretation of the current Taxonomy, according to which activities unable to report as sustainable are considered unsustainable^[34]See, for example, the statement in Carney, M. (2019)., which could distort the allocation of funds on the financial markets. Finally, an ET would also allow credit institutions and financial investors to recognize and support investment plans that put an end to harmful environmental performance and achieve a stable improvement in environmental performance.

The Platform notes that the building blocks of an ET are already contained in the current TR, given that for each environmental objective it is defined what is meant by significant harm (SH) (art. 17) and that TSC are required (Art. 10-15) that specify the conditions identifying SH (Art. 19(1)). As a consequence, failing such TSC is technically equivalent to causing SH.

While for activities violating the TSC for SH, technological solutions are available that allow to improve the environmental performance, there are other activities for which no such technological possibility of improving exists. The Platform recommends that the activities in such a situation be identified, in addition to the activity of power generation from fossil fuels mentioned in Art. 19 (2) of the TR. The whole set of harmful activities would therefore have two components which do not differ in terms of how harmful they are but in terms of future perspective: the activities for which no possibility of improvement exists can only be decommissioned while the others can be either decommissioned or undergo an investment plan for improving their environmental performance.

This implies that the TR technically defines three levels of environmental performance: 1) sustainable; 2) harmful; 3) intermediate (for activities doing no significant harm to environmental sustainability nor providing any SC). It is important to note that being in the intermediate area is not the same as having no (or low) significant impact (NSI) on environmental objectives and that proactively identifying a classification of NSI activities would support businesses to show that the activities they carry out are not harmful.
However, the classification of economic activities on three levels cannot be given regulatory power, for the fact that the scope of application of the TR, as defined in Art, 1(1), is limited to establishing “the criteria for determining whether an economic activity qualifies as environmentally sustainable for the purposes of establishing the degree to which an investment is environmentally sustainable”.

For this reason, the Platform recommends that the Taxonomy should be extended, with a priority given to the classification of significantly harmful activities in order to timely identify the activities for which either the dismissal or transition plans towards better environmental performance, even if not yet sustainable (‘intermediate transition’), are urgent and possible. If compliant with specific requirements in terms of credibility and science-based ambition of the improvement and framed in the long-term environmental strategy of the company, such ‘intermediate transition investments’ could be recognised in the EU legislation for sustainable finance in order to receive support by private financial investors.

According to the Platform, it would be essential that ET be part of a wider set of EU policy and legislative initiatives aimed at incentivizing finance for urgent transition away from environmentally significantly harmful activities. Indeed, due to its role as cornerstone, the ET would release strong synergies with legislation launched as part of the Action Plan amplifying their effects. Some examples can be provided for further reflection.

For large investors, the possibilities of channeling funds towards environment friendly projects would increase in relation to the wider set of information disclosed by non-financial undertakings which would also broaden the effects of the proposed CSRD. Corporate communication, no longer limited to sustainable activities, would allow to identify intermediate transition investments. Building on the ET and the extended reporting obligations, the forthcoming legislation on the EU GBS could be enriched by merely applying the use-of-proceeds approach to bonds issued to finance intermediate transition plans that have the necessary requirements. New forms of sustainability linked loans and bonds could be designed by aligning terms and conditions to the implementation of an intermediate transition plan.

Retail investors could have the possibility of expressing their preferences regarding sustainability in a more articulated way by making reference to supporting intermediate transition, which would establish significant synergies with the changes made in the Mifid II and IDD delegated regulations. The effects of the planned EU Ecolabel for environment friendly financial product could also be strengthened by introducing a specific label for retail financial products respecting specific thresholds defined considering the proportion of the underlying investments invested in intermediate transition plans. Financing intermediate transition investments could be considered under the SFDR for providing information on how and to what extent the investment underlying a financial product can qualify as financing an intermediate transition plan. It could also be investigated the possibility of coordination between the concept of PAI and that of SH in the context of both the SFDR and the regulation on financial advice.

Credit institutions and supervisors would be given an important tool to qualify the assets that are more exposed to environmental risks to be used in defining business planning, credit policies, engagement policies with borrowers and investee companies, risk management systems, stress testing exercises, and governance arrangements, and, as a consequence, to be considered in supervisory reviews and in macroprudential analysis^[35]It is for this reason that the Network for Greening the Financial System was among the first to put forward the proposal for a taxonomy classifying not only green activities but also “bown” … Continue reading.

Implementing the ET would require the need for further reflection, impact analyses, review of some published DNSH criteria, amendments to EU legislation both already in force and to be enacted, that is a series of steps whose complexity cannot be denied. However, to promote a voluntary use of ET concepts to submit transition investment plans to financial markets or to develop financial instruments specifically linked to intermediate transition objectives could accelerate the drive for better environmental performance in the EU.

 

References

Alessi, L., Ossola E. and Panzica, R. (2020). The Greenium matters: greenhouse gas emissions,environmental disclosures, and stock prices. Publications Office of the European Union, Luxembourg, April.

Amzallag, A., Levi, M., and Vasios, M. (2022). Text mining ESG disclosures in rating agency press releases, ESMA TRV, 10 February.

Basel Committee on Banking Supervision (2020), Climate-related financial risks: a survey on current initiatives, April.

Berenguer, M, Cardona, M, and Evain, J. (2020). Integrating Climate-related Risks into Banks’Capital Requirements, Institute for Climate Economica, March.

Berg F., Kölbel J., and Rigobon R. (2019). Aggregate Confusion: The Divergence of ESG Ratings, MIT Sloan Research Paper, Cambridge (Mass.).

Carney, M. (2015). Breaking the tragedy of the horizon – climate change and financial stability, speech at Lloyd’s of London, London, 29 September.
Carney, M. (2019a), Fifty Shades of Green, Finance and Development, December Vol. 56 No 4.

Carney, M. (2019b). A New Horizon, speech at the European Commission Conference: A global approach to sustainable finance.

EBA (2021). Report on Management and Supervision of ESG Risks for Credit Institutions and Investment Firms, 23 June.

ESMA (2019), Final Report. Guidelines on Disclosure Requirements Applicable to Credit Ratings, 18 July.

ESMA (2021), Letter to the European Commission, 29 January.

EU Technical Expert Group on Sustainable Finance. (June 2019) Report on EU Green Bond Standard. Proposal for an EU Green Bond Standard.

European Commission (2020), Consultation Document: Review of the NFRD, 20 February.

Konstantas, and Antonios et al. (2021). Development of EU Ecolabel criteria for Retail Financial Products, Technical Report 4.0, JRC Technical Reports, March.

NGFS (2019), A Call for action. Climate change as a source of financial risk, April

Platform on Sustainable Finance (2021), Public Consultation Report on Taxonomy extension options linked to environmental objectives, July.

Authors

Daniel Mikkelsen^[1]Senior partner in McKinsey’s London office., Simona Viscardi^[2]Partner in McKinsey’s Milan office., Massimo Montes^[3]Engagement manager in McKinsey’s Milan office. and Francesca Paola De Amicis^[4]Associate in McKinsey’s Milan office.

 

In the last couple of years, banks have shown significant progress with respect to ESG (environmental social and governance) and climate change management, undertaking several actions: outlining ESG and net-zero strategies, setting up dedicated board-level governance and organizations, developing risk management frameworks which allow to estimate and mitigate climate risk, and reporting and disclosure frameworks which promote increasing transparency and comparability towards the markets.

Having set the basics on climate change management will allow banks to play a flywheel role in supporting climate transition, acting as a “multiplier” for the significant public funds allocated to green transition within the Next Generation EU and local recovery plans, and tackling significant business opportunities, both in terms of lending and funding (sustainable loans and green bonds) and in terms of sector-specific products to mitigate climate risks (e.g., insurances in agriculture) or commission-based services to facilitate the transition (e.g., to electric vehicles).

The acceleration of EU banks towards the green transition has been pushed by several forces: investors, regulators and supervisors, competitive pressure, general public, and think-tanks.

In this article, we will deep dive on the regulatory and supervisory initiatives which have significantly induced banks towards an acceleration in managing climate-change challenges: we will provide an overview of the most important regulations and supervisory expectations; outline respective implications for banks; focus on what still needs to happen for banks to support the transition at full potential, both in terms of enabling factors (e.g., skills, data) and remaining business challenges.

In line with the current status of the banking industry, although in this article we mostly focus on climate-change, in multiple instances we extend the discussion to ESG aspects more broadly (including the social and the governance ones), within the dimensions where banks are addressing them more comprehensively. Specifically, despite environmental risks include other factors beyond climate, so far banks have concentrated their actions on climate-related ones, while practices around other environmental factors (e.g., natural disasters or biodiversity) in Europe are just emerging as we speak.

 

1. Context

Climate change is no longer optional. The world is rapidly moving towards a resource efficient economy, with a global sustainability push driven mainly by a significant increase in climate-related policies, investments in renewable energy capacity and governmental sustainability-related financing.

In this evolving scenario, the European Union is acting as a first mover, especially because of the climate regulatory and supervisory pulse that has arisen in recent years. As a matter of fact, the EU is front running – among others – the process of setting global standards, for instance through the signing of the EU Green Deal that entails direct implications on more than 200 regulations with its aim for the European Union to become the world’s first “climate-neutral bloc” by 2050 across different sectors. Moreover, the EU has launched a dedicated effort to finance sustainable projects through public funding with its €1.8 trillion of Next Generation EU Recovery Plan, including priority initiatives focused on energy efficiency and building requalification, green transition and sustainable local mobility, protection and enhancement of the territory and of water resources, green enterprises and circular economy. The European Union has also been the region mainly driving the push towards clear commitments during COP26 (including the setting of the target for coal-fired power phase-out by 2030 for most countries and the launch of the Global Methane Pledge).

Moving to the rest of the world, the United States – committed to net zero emissions by 2050 and supporters of the Global Methane Pledge during COP26 – are riding the climate change momentum with an increased political focus and a strong local sentiment of sustainability accompanied by ambitious targets to reverse climate policies.

To conclude the quick snapshot of the worldwide panorama, China and India set their carbon neutrality objective by 2060 and 2070, respectively, and are making progress in climate targets leveraging a rigorous and efficient execution power, yet still with significant room for improvement.

Financial institutions have crucial roles to play in the transition to net zero, which requires about €28 trillion cumulative investments by 2050, spread across different industries, mostly transportation and aviation, construction, and power generation.
Although the road to net zero is far from clear and the “path to net-zero equation” is not solved yet, leaders in the financial industry are playing offense and are embarking on efforts to develop a full potential view on how to achieve net-zero emission targets while capturing growth opportunities, innovating on product development, and creating competitive distance.

Climate and ESG topics have become increasingly important. Four forces are converging to make climate change a top-of-mind topic for senior bank executives:

1. Pressure from investors and other stakeholders. Investors are factoring into their choices the risk deriving from environmental impacts linked to the activities of companies. There is a growing awareness that ESG factors have a strong influence on a company’s long-term performance. Investors and the public have pressured the largest banks to commit to net-zero portfolio alignment.
2. Rapidly evolving competitive landscape and peer pressure. Financial institutions are accelerating on public commitments to net zero and on the definition of financed emission targets. The creation of dedicated initiatives and alliances (e.g., Net-Zero Banking Alliance (NZBA), Net-Zero Asset Managers Initiative (NZAMI)) has pushed financial players towards a new set of methodological standards and disclosures. As of January 31, 2022, more than 100 global banks have indeed made commitments since the creation of NZBA (April 2021) to realign their portfolios toward these goals. Over half of these are in Europe, with many more expected. Furthermore, new methodologies have been identified to scientifically measure financed emissions and set targets (e.g., SBTi – Science Based Targets initiative).
3. Heightened regulatory requirements and supervisory expectations. The current regulatory and supervisory context has been evolving rapidly, with tighter climate-specific expectations already issued by the European Commission (EC), the European Banking Authority (EBA), and the European Central Bank (ECB).
4. Increased scrutiny by NGOs and more green activism events. The continuous publication of dedicated reports focusing on emission reductions and climate-related topics, coupled with activists’ events against banks (the Global Day for Climate Justice and Greta Thunberg’s Fridays for Future Activists are just two examples) are pushing even further the level of awareness of the net zero imperative for credit institutions.

The accelerated pace of climate support actions posed by the four above-mentioned forces also stimulates the adoption of new business models and shapes new strategies, opportunities that banks can explore by renewing products and services supporting the transition (e.g., green sustainable lending, green bonds). In fact, banks have the occasion to act as a catalyst for corporates in the highest emitting sectors and for retail clients, whose consumers’ and investment profiles are more and more ESG-driven.

As this article is focused on regulatory requirements and supervisory expectations related to climate change and, to some extent, more broadly to ESG, in Section 2 we outline the most significant regulatory and supervisory actions banks are subject to, while in Section 3 we assess the implications for the banking industry and what still needs to happen for banks to properly support the transition.

 

2. EU banking regulation and supervision on climate change

Regulatory and supervisory pressure on European banks is among the strongest anywhere in the world and has significantly increased over the past months through a series of new regulatory requirements and guidelines, as well as supervisory activities conducted by the European Commission, the European Banking Authority and the European Central Bank.

As an overall direction, there is a push towards additional and enhanced transparency, including reporting and disclosure regarding the broader climate and sustainability matters, covering the identification of ESG sustainable products, climate risk exposures and climate risk management.

 

ECB supervision on climate and environmental risks: supervisory guidelines, stress testing and thematic review

In November 2020, the ECB published the Guide on climate-related and environmental risks, including 13 expectations that call for banks to rapidly step up their capabilities, dealing with several aspects of climate and environmental (C&E) business strategy, governance, and risk management. These expectations aim to increase the level of transparency and accuracy of all C&E domains for banks, in particular:

– Understand and integrate C&E risks within the business environment and develop a climate strategy, consistent with net-zero aspiration

– Include C&E risks within the risk appetite framework and the existing risk management framework by identifying, quantifying, managing, monitoring, and mitigating these risks

– Assign responsibilities for C&E risks management throughout the organization in accordance with the three lines of defense framework

– Consider C&E risks at all relevant stages of the credit underwriting and monitoring processes, as well as their impacts on the other types of risk (e.g., operational, reputational, market, strategic and legal risk)

– Establish internal reporting on material C&E risks and regulatory disclosures on climate-related practices

– Assess the impact of climate events on banks’ portfolio, through scenario analysis and climate stress testing exercises.

Following the release of the ECB Guide on climate-related and environmental risks, banks were requested to conduct a self-assessment in line with the 13 expectations outlined and to develop multi-annual implementation plans to advance C&E risk management (May 2021).

Additionally, since February 2022, the ECB has carried out a thematic review of banks’ practices, verifying their progress against commitments taken through implementation plans. This exercise will act as forcing device to make sure that even long-term climate commitments are turned into actions and timely delivered. In parallel to the thematic review, the ECB has conducted the first climate stress testing, which involves about 110 participating banks with different requirements, based on proportionality principle.

Both thematic review and stress testing outcomes will be gradually integrated into the SREP (Supervisory Review and Evaluation Process) assessment, initially only qualitatively and without resulting in additional capital buffer.
In the next years, also quantitative impacts will be assessed through SREP for C&E risks, in which case further measures would be required for mitigation (e.g., additional capital buffer).

The ECB has been neither the first nor the only supervisor conducting a climate stress test in Europe recently. For instance, other jurisdictions have seen national supervisors leading stress testing exercises even at earlier stages, such as Banco De España starting from transition risks in Spain, ACPR-Banque de France piloting both physical and transition risks for banks and insurers, De Nederlandsche Bank pioneering in 2018 an energy transition risk stress test for financial institutions in the Netherlands.

 

Principles and regulations to enhance transparency on green activities – EU taxonomy, reporting, and disclosure

«Increasing transparency makes markets more efficient and economies more stable and resilient.» As stated by Michael R. Bloomberg ‒ Chair of the Task Force on Climate-related Financial Disclosures (TCFD) established by the Financial Stability Board (FSB) ‒ climate-related financial risk disclosure has increasingly become a burning priority of multiple stakeholders, from regulators and supervisors to investors.

At the moment, more than 3,000 organizations in almost 90 countries are supporting this initiative, of which more than 1,000 financial institutions, with several banks already publishing their TCFD report, including almost all top tier EU banks.

Recently, in January 2022, the EBA has published its final draft of the Implementing Technical Standards (ITS) on Pillar 3 disclosures on ESG risks, focusing on some priority aspects, for example:

– Transition and physical risks, including information on exposures towards carbon-related assets and assets subject to chronic and acute climate change events

– Climate change connection with other “traditional” risks financial institutions are exposed to

– Mitigating actions to address those risks, including supporting counterparties in transitioning to a carbon-neutral economy and adapting to climate change

– “Greenness” of assets through relevant metrics, including Green Asset Ratio (GAR) and Banking Book Taxonomy Alignment Ratio (BTAR), to be disclosed from January and June 2024 respectively

– Qualitative information on how institutions are embedding ESG considerations in their governance, business model, strategy, and risk management framework.

Both TCFD standards and Pillar 3 package will significantly enhance comparability of external reporting on climate, currently quite fragmented and considerably different institution by institution.

As part of Pillar 3 disclosure and Non-Financial Reporting Disclosure (NFRD), the Green Asset Ratio (GAR) represents the main key performance indicator for credit institutions^[5]That are subject to the disclosure obligations laid down in Articles 19a and 29a of Directive 2013/34/EU, as the single metric creating transparency on the “greenness” of the bank’s balance sheet. The ratio allows investors and regulators to conduct peer-to-peer comparisons and foster policy directives towards green finance.

The European Commission and EBA have defined a gradual journey to reach the desired level of disclosure:

• Eligibility according to the EU Taxonomy to be disclosed in 2022 (reporting period 2021); the “eligibility” concept, however, only verifies the counterparties which can potentially play environmentally sustainable activities based on economic sector classification (e.g., afforestation, electricity generation from hydropower), without exploring the effective level of “greenness” of the company’s balance sheet, nor the “green” purpose of the operation to the specific client.
• Alignment according to the EU Taxonomy to be disclosed in 2023 by corporates and in 2024 (reporting period 2023) by financial institutions^[6]2024 for Loans and advances and off-balance-sheet items (guarantees, assets under management), 2026 for trading book and other non-banking services (fees and commissions). The “alignment” concept, more restrictive than the “eligibility” concept and at the basis of GAR computation, requires compliance with the so-called Technical Screening Criteria in terms of:
  • Substantial contribution to at least one of the six environmental objectives^[7]7 Laid down in Article 9 of Regulation (EU) 2020/852 (climate change mitigation, climate change adaptation, transition to a circular economy, pollution prevention and control, sustainable use and protection of water and marine resources, protection and restoration of biodiversity and ecosystems), outlined by an extensive list of highly technical sector-specific conditions
  • No Significant Harm (NSH) to the other environmental objectives
  • Conformity to minimum safeguards, recognizing the relevance of international minimum human and labor rights and standards.

As mentioned, the EU Taxonomy regulation for the purpose of calculating the bank’s GAR applies only to corporates within the scope of the Non-Financial Reporting Directive (NFRD). However, the NFRD is currently implemented and applied differently across EU countries (e.g., different revenue thresholds, listed vs. non-listed companies), with EU systemic banks currently facing an unleveled playing field. Going forward, regulatory changes are expected to move in the direction of increasing the pool of companies subject to disclosure obligations, which will also converge towards an enhanced level playing field at EU level. The EBA publication of its ITS on Pillar 3 Disclosures of ESG risks^[8]January 24, 2022, which introduces a new metric – the Banking Book Taxonomy Alignment Ratio (BTAR), complementing the GAR for smaller companies^[9]EU and non-EU non-financial corporations not subject to NFRD disclosure obligations not covered by the original EU Taxonomy – plays already in this direction.

 

3. Implications for banks, enablers, and key outstanding challenges

Climate and ESG related regulatory and supervisory expectations have significantly accelerated banks’ pace for addressing climate change and, to some extent, ESG-driven transformations more broadly. This acceleration has led to tangible results in multiple domains – e.g., strategy, governance and organization, risk management and credit – and has also revealed significant opportunities to support the energy transition.

In the following pages we outline the current status of the industry in this domain, the enablers banks need to put in place and the outstanding challenges to be overcome in order to effectively support the transition while preserving other holistic objectives (e.g., including social fabric support).

 

ESG and climate strategy

The definition of an ESG strategy is a board-level topic, which affects the majority if not all the activities of the bank. Banks are required to define their level of ambition across all ESG pillars, in which the “E” and climate change components represent just a fraction, despite the most prominent, of the overall picture.

Banks, in fact, are also expected to take into consideration the local economic specificities while setting their ESG strategy and targets. For example, for countries with a socio-economic fabric mainly driven by SMEs, the green transition is potentially slower and more complex due to scarcity of qualified skills and access to capital markets. In this context, banks not only could provide the financing to support the transition, but could also support the SMEs towards the transition and make sure, while setting a green strategy, to carefully handle the potential trade-off between climate targets and social implications: reducing financing to “brown” SMEs which are currently unprepared to the green transition could negatively affect regional economic “districts” (e.g., leather, chemical) or even national economies (e.g., forestry in Slovenia).

Sustainable corporate Governance (“G”) also plays a significant role: as many empirical studies have shown, both investment returns and credit losses are highly correlated to governance KPIs. Companies which are ranked high on “sustainable governance” KPIs have proved higher long-term returns and stronger resilience. Banks rating models to assess credit risk have incorporated governance assessment since quite a while and have recently been enhanced in line with ESG principles.

Back to green strategy to address climate change, one of the most successful climate initiatives which has so far involved more than 100 banks worldwide ‒ and more than 50 banks in Europe ‒ is the Net-Zero Banking Alliance. Banks adhering to the alliance commit to aligning their financed emissions to a net-zero pathway, i.e., deriving from lending to clients, on selected high-emitting sectors with intermediate 2030 targets to be set within 36 months from joining the alliance and own bank emission by 2050.

Top-tier European and US banks have already started publishing commitments on their high-emitting sectors, usually starting with oil and gas, power generation, automotive and coal mining.

It is worth noting that some sectors are already following a net-zero trajectory thanks to the actions and enforcement of policy makers (e.g., renewable energy incentives, EU limits to automotive vehicle emissions, etc.). In those cases, banks act mainly as financing provider to support the transition plans of the clients. For other sectors, policy makers have not intervened with stringent rules or policies, either because the switch to new green technologies is expected to be slower (e.g., oil & gas) or because the technologies to address the climate topics are not yet available (e.g., agriculture). In these cases, banks act not only as financing providers to support the transition, but also as sponsors promoting accelerated alignment to net-zero objectives.

In order to achieve ambitious net-zero objectives, banks should also set up a holistic framework covering strategy, risk management, planning, credit, and business steering. More in detail, banks should activate the following key areas:

• Business steering: engage with clients on transition plans and foster origination towards virtuous players and market segments. Support clients not only through financing but also with advisory services (e.g., insurance, investments, capital markets advisory)
• Credit: ensure climate strategy operationalization through a credit underwriting and monitoring framework, which supports “green” products and operations, while also assessing and pricing climate risk properly
• Planning: ensure consistency of climate targets with the overall bank strategy and monitor progress against targets
• Risk management: ensure proper oversight of transition and physical risk related to climate targets and ambitions.

 

ESG and climate governance

Organizations feel the need to equip themselves with a renovated set of competences as well as “dedicated venues” within which they can discuss sustainability and climate change. In fact, more and more boards of directors have created dedicated ESG risk committees, empowered by use of newly integrated ESG tools, to support development of sustainability strategies.

At managerial level, several organizational archetypes are emerging, with ESG and climate responsibility assigned to different organizational levels. Broadly speaking, organizations can either adopt: (i) A centralized model, where a Chief^[10]Mandatory for UK banks or Head of Climate and Sustainability and central ESG teams are usually appointed (either creating a new dedicated role or embedding it within an existing role), whose primary focus is on overall aspiration, partnerships, and communication; or (ii) A more decentralized model, spread throughout the organization, where functional skills at business-unit level are enhanced and coordinated, and interactions among different functions are ensured through the designation of a focal point (for example, a sustainability ambassador) for each area. Hybrid models are also more and more popular, with centralized ESG units (normally CEO-2 level) playing a coordination role, above all on new project-based initiatives, and functional skills spread across the organization (as per decentralized) model, for the respective areas of competence.

Considering the high specificities of climate topics, which often require scientific skills and industrial expertise, many banks are creating a “climate center of excellence” to perform highly specialized services (e.g., climate scenarios, modeling, energy transition plans assessment) in favor of different units of the bank.

Beyond “hard” skills, an increasing “climate change sensitivity” is perceived in most financial institutions at all level; however, while at a top-management and managerial level this is clearly reflected into daily operations, also through ESG-linked remuneration policies and performance management targets, at a more operational level climate change culture and climate risk awareness are still more scattered (multiple employees still look at “ESG and climate-friendly” actions as “marketing campaigns” and are not fully aware of the end-to-end concrete climate journey their organizations are undertaking). Climate culture dissemination and “ton from the top” will be crucial in the year to come, in order to turn recently introduced climate-related frameworks into real actions across the whole organization.

 

Risk Management and Credit Framework (including pricing)

Climate risks are becoming more and more evident. On the one hand, acute physical extreme events are becoming more frequent and severe (e.g., floods and droughts) and chronic impacts gradually more evident (e.g., temperature rises); on the other hand, transition risks are becoming even more concrete (e.g., methane pledge, oil price rises). As such, banks are facing increasing pressure to identify and manage climate risk in their portfolio. Banks should therefore include climate and environmental risk considerations within their risk management framework, to ensure a timely identification and monitoring of climate risk of their portfolios. As a prerequisite for climate risk inclusion into the overall Risk Management framework, a materiality assessment is performed. The materiality assessment aims to: (i) Identify the physical risk hazards and transition risk determinants which are relevant for the bank, based on sectors and geographies where the bank (and its clients) operates; (ii) Assess inter-dependencies and correlation of climate risk with the other risks the bank is facing, especially credit, operational, reputational, and legal risks in the long, medium, and short term.

On the basis of the materiality assessment outcome, banks are expected to develop unbiased methodologies to assess climate-risk impact on other “standard” risk types, both in terms of “qualitative relationships” (i.e., developing a narrative on how climate risk hazards and events drive other risks) and quantitatively. Climate risk should therefore be fully integrated into the risk taxonomy and, as a consequence, embedded into the Internal Capital Adequacy Assessment Process (ICAAP).

ICAAP integration goes hand-in-hand with the setup of a stress testing framework, which not only assesses the impact of potential climate risk scenarios on the bank’s portfolio, but is also fully integrated into the overall “general” stress testing framework, feeding highly strategic processes like the Risk Appetite Framework (RAF) and strategic planning. While banks, due to the ECB supervisory pressure, are significantly advancing on developing methodologies for granular climate risk impact estimation, they are all still facing significant challenges in integrating it into the overall “managerial” framework.

Beyond climate risk assessment and measurement, in order to steer the business towards “greener” or more “ESG-friendly” strategic objectives, banks should integrate climate and ESG considerations within the credit processes, also intervening in different elements of the credit framework, from the highly strategic ones (e.g., RAF), which steer the overall portfolio, to the more operational ones (e.g., single-name underwriting process).

Firstly, climate risks should be integrated into the set-up of the bank’s risk appetite. Sectorial limits should be developed to steer the business towards the desired portfolio composition.

Secondly, a climate risk assessment (counterparty score) should be developed at a sector and counterparty level to differentiate clients within high climate risk sectors and identify those who committed to a transition path.

Thirdly, the climate risk assessment should be integrated within the underwriting process: clients exposed to high climate risk, who did not undertake solid transition paths could be subject to reinforced mechanisms of the underwriting process to be granted new lending (e.g., higher level of credit authorities, involvement of second LoD – Line of Defense). Moreover, green products and financing supporting companies into the transition towards greener activities could be encouraged also through pricing incentivizes.

In the Large Corporate market, green finance currently commends around 25-30 percent lower pricing compared to standard products, reducing commercial banks’ margins. This impact on margins is particularly relevant for banks with higher cost of funding, for which being competitive in the green finance market is currently a significant challenge. Commercial banks are currently requesting EU regulators and supervisors to reflect a “green finance premium” as part of lower cost of funding and lower capital absorption. European regulators and supervisors are already working along this direction, for example the ECB monetary policy review will include lower haircuts for “green assets” pledged to ECB; and a review of CRR regulation towards differentiated capital requirements for green asset is also expected in 2023. As represented in the paragraph related to EU Taxonomy and Green Asset Ratio, flagging “green exposures” according to homogeneous criteria and transparency on methodologies undertaken will be key to provide supervisors confidence for incentives recognition.

 

Business opportunities

Governments and companies are increasingly committing to climate actions, yet significant challenges remain, not least the scale of economic transformation required to complete a net-zero transition entails the difficulty of balancing the substantial short-term risks of potentially less prepared and uncoordinated action with the longer-term risks of insufficient or delayed action.

The transition would be universal, significant, and front-loaded, with uneven effects on sectors, geographies, and communities. Even if climate change is oftentimes viewed only from a risk perspective (especially given the rapid development in prudential regulations and focus point of disclosure frameworks), it simultaneously holds plenty of growth opportunities for corporates and financial institutions, including banks, funds, and insurance companies.

Realizing climate-related business opportunities is a win-win situation for both business and risk: in terms of revenues and volumes, it allows to offset the selective deleveraging actions in certain sectors with extremely brown clients or mitigate the lower spreads applied to green finance. However, it also forms a risk mitigation. For example: funding projects which contribute to the energy transition or clients which aim to reduce the emissions-intensity of their business activities is typically associated with lower levels of transition risk being assumed; developing customized insurances for territories and sectors (e.g., agriculture products) subject to physical risk would also mitigate the risk position.

A growing number of leading banks and other financial institutions is focusing on new strategies to grow, revising their product offerings, setting strategic goals for green and sustainable financing volumes, and collecting earmarked funds through issuances of green and sustainable bonds.

Consequently, competition in the sector is intensifying, requiring financial institutions to double down on their positioning and find ways to differentiate themselves. Clients no longer seek only providers of finance, but rather partners in the transition. For banks, this may entail the development of dedicated sectoral expertise to be able to advise customers on technological solutions, project planning, and execution, or to provide perspectives on broader industry developments. Banks could strategically position themselves in certain sectors, in line with their business model and environment, and create ecosystem partnerships with fintech and industrial players to develop specialized products and services (e.g., in electricity vehicles markets).

Enablers

The actions noted above should be supported by key enabling factors such as:

• Data and data strategy. Climate data are currently not available to banks in a comprehensive way. In particular, while climate science has extensive literature on climate scenarios, taxonomies, etc., almost no historical data is available on climate-related losses. In addition, data availability largely depends on the type of counterparty: large corporate clients in high emitting sectors are experiencing equivalent regulatory push, they are therefore starting producing and disclosing climate data, while SMEs are not. In order to face the data challenge, banks should consider the “ESG and climate data requirements” landscape as a whole (i.e., including scenarios, hazards, counterparty data like scores, emissions) and develop a data strategy accordingly. In this context, several “make-or-buy” decisions need to be taken. Multiple data providers are available in the market and have significantly expanded their services over the last years; however, none of them cover the full spectrum of banks’ needs. Banks could therefore develop an ESG data strategy to ensure consistent and synergic coverage of all data needs.
• Climate skills. To face such a technical topic like the climate change, which requires to combine scientific knowledge, industrial sectors knowledge, and experience with banking processes to “make things happen”, banks should decide: (i) Which kind of capabilities they want to internalize vs. gather externally (e.g., for climate scenarios, the most of banks will still be willing to leverage external energy authorities projections without any in-house development); (ii) Which/Where capabilities need to be enhanced (e.g., stress testing, financed emissions measurement and portfolio alignment, transaction due diligence); (iii) How to develop internal capabilities (e.g., hiring of climate scientists or sector specialists, training and capability building) vs. outsource selected activities (e.g., transition plans reviews).

 

Key challenges for banks

Despite significant progress made over the last couple of years in introducing ESG factors and setting up end-to-end framework to handle climate change and support climate transition, there are still significant challenges ahead:

a. Banks are requested by regulators to steer their portfolios towards net zero at a certain accelerated pace, in some sectors commanding more ambitious trajectories than what current commitments from clients foresee, due to lack of technology (e.g., agriculture) or high conversion costs and slow conversions to renewables (oil & gas).

b. Energy transition has been tackled by big industrial companies belonging to brown sectors, however smaller companies (e.g., SMEs) seem to lag behind. Despite selected “best in class” cases, an integrated value chain approach could be envisaged from big companies (and financial institutions) to enable SMEs to also converge towards green targets.

c. There are significant cases where “ESG negative sectors or counterparties” are key drivers of national and local economies (e.g., coal in Eastern Europe, forestry in Slovenia, tobacco in Egypt, textile, or leather manufacturing in some industrial districts); in these cases, banks need to balance the trade-off between being “climate captain” and the mission of supporting local economies and people.

d. Level playing field and alignment of incentives – while banks are committed to support the transition, policy makers and regulators are expected to put in place the necessary incentives, e.g., lower capital absorption and cost of funding for green activities, which banks can reflect into pricing to clients.

4. Conclusion

Financial institutions play a critical role in the field of sustainable development and are strongly committed to act as a flywheel towards the green transition and the goal of net-zero emissions by 2050.

The opportunity to change is concrete and Europe is paving the way with significant financing activities to support the transition. Along with this, governments, regulators, and supervisors are pushing financial institutions and all other relevant stakeholders to act now and ensure they are all meeting the mutually accepted standards and targets.

In this evolving scenario, banks are making a significant step-up creating the “foundations” to support and enable this transformation: by integrating ESG and climate components as key pillars in their business strategy and developing concrete sector-specific business opportunities; by defining new governance and organizational layouts to address the sustainability agenda; by developing a renovated set of dedicated skills and capabilities together while promoting an internal ESG and climate culture; by revising their risk management frameworks to better identify and tackle climate risk.

Nevertheless, there are still significant challenges: sensitive trade-off mainly connected to the social fabric (“S”) in specific countries or industrial districts and technological challenges on specific sectors (e.g., agriculture) still need to be sorted out to stand up to net-zero commitments and implement them across the board.

Authors

Hans Degryse^[1]KU Leuven and CEPR., Roman Goncharenko^[2]KU Leuven., Carola Theunisz^[3]KU Leuven. and Tamas Vadasz^[4]KU Leuven.

 

1. Introduction

Climate change is one of the largest environmental hazards affecting our society. There is a scientific consensus that greenhouse gas (GHG) emissions are at the root of the problem, the consequences of which are widespread. In particular, the rise in GHG emissions in the atmosphere is associated with an increase in global temperatures leading to extreme weather events and sea level rise, amongst others.

Governments have not been ignorant with regard to climate change. Already in 1992, the United Nations Framework Convention on Climate Change (UNFCCC) was established in order to ‘stabilize greenhouse gas emissions in the atmosphere’. Each year, the Conference of the Parties (COP) meet to assess the progress in dealing with climate change, to make pledges and to set out future objectives concerning climate change policies. The Paris Climate Accord (COP21) was the result of the 2015 convention. This Accord, signed by nearly 190 countries, aims to limit the increase in average global temperatures to 1.5 degrees Celsius relative to the pre-industrial level. The pathway towards a carbon-neutral economy is often referred to as the green transition.

As a contribution to the green transition, countries have submitted national climate action plans, the so-called nationally determined contribution or NDCs. At the most recent convention, in Glasgow 2021, countries re-engaged ‘to keep the target of 1.5 degrees Celsius alive’. That is to say, the original pledges and climate policies were not sufficient to protect the planet from warming further, rising above the aimed 1.5 degrees Celsius. However, as Figure 1 below depicts, considering the current exhaust of GHG emissions and the expected warming based on the current NDCs, the projected warming will still far overshoot the aspirational Paris Accord target. In fact, as illustrated in the chart below, the policy gap is quite substantial.

 

Figure 1. 2100 Warming Projection: Emissions and expected warming based on pledges and current policies.

Source: Solactive, Climate Action Tracker (2021)

 

The uncertainty regarding future regulatory adjustments and the risks posed by climate change presents investors with significant challenges. These challenges are broadly classifiable into two risk groups. First, the financial system faces physical climate risks. These risks impact the financial sector directly. For example, as natural disasters occur more frequently and become more intense due to climate change, the materialization of climate-related physical risks can potentially result in large financial losses. Second, transition risks can be defined as risks of financial losses or economic dislocation related to the pathway towards a low-carbon economy and the accompanied policy tightening. They may impact the financial sector indirectly, through shifts in asset- and collateral values or higher costs of doing business. Physical risks and transition risks may interact with one another. For example, not making a transition (with effective policy measures) implies that the physical risks from climate change are likely to increase over time. Or the other way around, regulatory intervention which substantially speeds up the green transition at short-term economic costs could reduce the probability of future physical risks.

The Paris Climate Accord highlighted the role the financial system should play in accelerating the green transition. In fact, it recognized that finance could contribute to a swifter green transition provided that investors, financial institutions and other stakeholders would price in climate-related externalities. These externalities, which are at the root of the matter, are not yet consistently reflected in equilibrium prices. Because the current participants in the financial system that fund these activities do not necessarily suffer the losses and gains resulting from changes in physical or transition risks – most of which occur in the future – the financial system does not always internalize these losses and gains when making funding decisions. The green transition thus requires regulatory intervention that aims at internalizing climate-related externalities. By provoking the internalization of climate-related externalities such as GHG emissions – either directly through carbon taxes or other legislation affecting carbon-intensive industries – a market-based process of resource allocation can arise. This process is crucial to avoid market failure due to climate-related risks in the long run. Despite commitments already made, there is substantial uncertainty about when and how exactly such regulatory adjustments will take place, and whether decision makers are willing to take the potential short-term political costs. Such uncertainty makes particularly difficult to measure and rationally price in both types of climate risks.

 

2. A review of the empirical evidence

There is a growing body of evidence demonstrating that investors factor in environmental risk in their funding decisions, either because of their specific preferences (Riedl and Smeets, 2017) or because of the physical or transition costs that the risk entails (Krueger et al., 2020). There is empirical evidence that environmental risks are priced in equity markets (Bolton and Kacperczyk, 2021), option markets (Ilhan et al., 2021), bond markets (Fatica et al., 2019), and real-estate markets (Bernstein et al., 2019).

At the same time, the evidence on bank lending is more fragmented. For example, firms with environmental risks pay a higher loan spread and obtain loans granted by syndicates with fewer banks (Chava, 2014). There is also a significant negative relationship between voluntary disclosure of CO2 emissions and loan spreads for informationally opaque borrowers (Kleimeier and Viehs, 2018). Some further evidence indicates that environmental risks related to firms’ direct emissions are priced, but studies do not find differential pricing of these risks by green banks (Ehlers et al., 2021). Delis et al. (2021), however, find that green banks started to impose higher costs on syndicated loans to fossil fuel firms exposed to climate policies after the acceptance of the Paris Climate Accord.

Studying aggregate market outcomes, De Haas and Popov (2019) show that countries relying more on equity financing relative to bank lending are associated with lower per capita emissions and more green innovations, because stock markets steer investment towards carbon-efficient sectors. This seems to suggest that credit markets are impeding the pace of the green transition. This observation might be particularly worrisome for Europe, because European firms are much more reliant on bank credit compared to U.S. firms, as shown in Figure 2.

 

Figure 2. Size of financial market segments, 2016.

Source: Schoenmaker & Schramade, “Principles of Sustainable Finance”.

 

Relatedly, Degryse et al. (2020) demonstrate the existence of banking barriers to the green transition. In particular, banks’ legacy positions might induce credit rationing barriers to entry for innovative firms in polluting industries with large exposures to green technology disruption. Banks might decide to ration firms when their projects threaten to devalue banks’ legacy portfolio, either via collateral value drop or increase in probabilities of default. They further show that the banking market structure affects the rationing of new projects because firms face greater credit rationing when banks have homogeneous exposures to that industry.

When Green Meets Green

Yet, our recent paper shows that (at least a subset of) the banking system may be conducive to the green transition as banks are favourably pricing loans to firms exhibiting climate awareness (Degryse et al., 2021). In particular, we investigate whether and how the environmental consciousness (“greenness,” for short) of both firms and banks is reflected in the pricing of bank credit. Using a large international sample of corporate syndicated loans, we find that firms are indeed rewarded for being green in the form of cheaper loans. However, this only holds when borrowing from green lenders and, moreover, only after the ratification of the Paris Agreement. Hence, we find that environmental attitudes matter when “green meets green”.

Our empirical analysis requires proxies for the greenness of firms and banks. We classify a firm as green if it voluntarily reports to the Carbon Disclosure Project, an investor-oriented non-profit initiative to facilitate and standardize disclosure of a firm’s environmental impact. Firms reporting to the Carbon Disclosure Project are expected to have better in-house capabilities to measure and manage their exposure to the green transition of the economy, which can be viewed as evidence of their environmental consciousness. While previous studies showed that environmental performance as proxied by environmental scores matters for lending decisions, we refrain from using such metrics as these are often inconsistent over time, across industries, and among different providers (Berg et al., 2019). As such, our employed metric for firm’s greenness – which reflects a forward-looking measure of firm’s management of the risks posed by the green transition – seems to be more adequate to steer clear of discretion in methodologies.

Banks are classified as green if they are members of the United Nations Environment Programme Finance Initiative (UNEP FI), which aims to “mobilize private sector finance for sustainable development”. Since its creation in 1991, more than 160 leading banks have joined the Initiative. By stating their adherence, banks align their corporate governance with the UN Principles of Responsible Banking. Beyond setting objectively measurable targets with regard to their business activities, signatory banks commit to larger transparency with regular public reporting. To demonstrate that UNEP FI membership is beyond an empty promise, there is evidence that the Initiative’s signatory banks can issue green bonds with a premium because they can more clearly signal their environmental attitudes in lending (Fatica et al., 2019).

Using these proxies, we analyse the price information of corporate loans using a comprehensive international syndicated loans database for 2011–19. Figure 3 displays the loan spread density for both green and non-green firms in our sample. For green firms, the loan spread distribution is less right-skewed than for non-green firms. This already gives a first indication of a large unconditional green-effect and provides the basis for a more thorough econometric analysis. Unlike previous studies, we take a different tack by shedding light on the importance of lenders’ environmental attitudes in loan pricing decisions and examine whether the green-effect is stronger for loans given by green lenders in particular. We further investigate whether the Paris Agreement, which was reached on December 12, 2015, affected the relationship between firms’ and banks’ environmental attitudes and loan credit spreads.

 

Figure 3: Spread distribution of green vs. non-green borrowers.

 

Our results reveal the presence of a statistically and economically significant “green meets green” effect. To be specific, we estimate that green firms enjoy an average discount of approximately 50 basis points relative to non-green firms when borrowing from full green lender consortia. This effect is economically large as it is equivalent to a discount of one fifth of average loan spreads. Importantly, while the green-meets-green effect is insignificant before the Paris Agreement, as can be seen in Figure 4, it is statistically and economically significant after the agreement. This suggests that the green-meets-green effect is intimately linked to changes brought about by the Paris Agreement. We confirm this with a difference-in-difference-in-differences regression model. Moreover, we show that this effect survives different econometric analyses ruling out all sorts of selection issues and controlling for variables that may confound our results.

 

Figure 4. Visualization of estimated average coefficient that captures the green-meets-green effect on loan spreads using a sub-sample of loans with origination date preceding the Paris Agreement and a sub-sample of those originated after the acceptance date. The regression analysis controls for a rich set of relevant loan, borrower and lender characteristics and, moreover, exploits variation within firm’s industry-country-year clusters.

 

Why would the Paris Agreement have such a large indirect impact on lending terms, and why is this restricted to green banks? There is no doubt that more intense public discourse of climate change raises awareness among market actors, but it is not immediately clear how awareness translates to a specific equilibrium pricing. We argue in the paper that the observed empirical pattern is consistent with third-degree price discrimination by green banks with respect to firm’s greenness. First, we interpret the Paris Agreement as a shift in the perception of green transition risk, both by firms and by banks. Shifts in public opinion could lead to political pressure to strengthen environmental regulation, which could harm firms – and their lenders – that do not anticipate such shocks. Various interventions, previously unprecedented, are now on the table. For example, in May 2021 Royal Dutch Shell, a major player on the oil and gas market, was ordered by a Dutch court to cut its carbon emissions faster, overruling the firm’s own transition plans. This signaled to the market an increased likelihood that the judiciary system would become involved in climate issues in the future.

When the realization of a risk event is more likely, it becomes more important and more profitable to screen borrowers with respect to their exposure to such risks. Our proxy for green bank, that is, costly commitments to engage in aligning the banks’ business with climate objectives, means that such banks are necessarily more equipped to understand – as well as to systematically reflect in their pricing decisions – borrowing firms’ climate risk exposure. Similarly, participation in CDP signals that the firm has invested prior effort in understanding and measuring its exposure to climate transition risk, so it is naturally in a position to better cope with an eventual realization of such risks. Building on their superior expertise, green banks will reward green firms and punish non-green firms more than non-green banks do so. Through this mechanism, the increased awareness induced by the Paris Agreement translates to our documented green-meets-green effect.

On balance, our findings indicate that a subset of banks (viz., green banks) play a positive role in the green transition as they are favorably pricing loans to green firms relative to non-green firms. This holds when banks have a similar environmental consciousness — our “green-meets-green effect”. Putting climate change on the agenda through the Paris Agreement has fostered this attitude.

 

3. Regulatory implications

The landmark 2015 Paris Climate Agreement sets out a global framework to mitigate dangerous climate change by limiting average global warming well below 2°C and pursue efforts to limit it to an aspirational 1.5°C. To achieve these objectives, it called its negotiators to work on all key areas including mitigation, adaptation, finance, technology development and transfer, transparency of action, and capacity building. This should strengthen countries’ ability to deal with climate change and support them in making efforts. Improvement along these areas is essential to build resilience and decrease vulnerability to adverse climate change effects, the success of which will depend on the efficacy of the before-mentioned nationally-determined contributions (NDCs). Moreover, it will also depend on the commitment of non-party stakeholders in harnessing technological innovation and generating a momentum for the wider economy to switch to a new, carbon-neutral production matrix. As such, the Paris Agreement lays out a bridge between today’s policies and a sustainable future. In this section we talk to a number of ongoing policy debates.

Climate-related reporting

Financial stakeholders can accelerate the green transition by supporting emission reducing strategies and promoting green technology development. However, to steer informed investment, disclosure of comparable and reliable climate-related data or metrics will be absolutely fundamental. Therefore, establishing best practices and mandating standards for high quality data is something we should put considerable effort into going forward. As a matter of fact, as we show in our paper, firms that manage climate-related risks and invest in climate-related disclosure will be rewarded for their efforts in terms of access to cheaper bank credit given by green lenders (Degryse et al., 2021).

This underscores the importance of global efforts such as the Task Force on Climate-Related Financial Disclosure (TCFD) Initiative which was established in 2015 in order to develop robust and internationally consistent climate-related disclosures. Increasing the amount of standardized and reliable disclosure will provide better access to data required to appropriately manage and identify the exposures to climate-related risks and opportunities, to compare across companies and industries, and ultimately facilitate the financing of the green transition. An international adoption of the TCFD recommendations, by both non-financial and financial companies, would allow financial stakeholders to assess the carbon footprint of their portfolios, and report on their commitments in a transparent, comparable and consistent manner. Moreover, it will greatly open up the scope for research in contributing to a greater understanding of climate risks, improving modelling practices in measuring risks related to climate change, and strengthening the stability of the financial system.

An encouraging trend in this regard is the speed with which central banks around the world are joining the Network of Central Banks and Supervisors for Greening the Financial System (NGFS) and taking steps towards TCFD-aligned financial disclosure. Cooperating under the NGFS-umbrella allows for deeper work on developing climate-related stress tests, integrating climate-related risks into financial stability monitoring and into monetary policy more generally.

Green Financial Institutions

What about bank financing? Demonstrating the role of banks’ legacy positions in their incentives to finance innovation, Degryse et al. (2020) stress the need for (public) green banks which are free from brown assets in order to promote the entry of innovative firms. As such, green bank initiatives could catalyse a swifter green transition by promoting competition and diversity among financial institutions and providing alternative funding sources for green technology innovation. Examples of such initiatives include the UK Green Investment Bank or the New York Green Bank. The introduction of legacy-free green banks would induce incumbent banks to counter-act the credit rationing of innovative firms.

In parallel, countries can take actions to counterbalance the tendency of credit markets in financing relatively carbon-intensive industries by introducing green credit guidelines that encourage banks to take environmental considerations into account in their lending decisions. For example, in 2014, the Brazilian central bank issued a number of resolutions on socio-environmental risk integration into banks’ risk management on top of the traditional credit, market and operational risks. This should help steer sustainable investment and improve the resilience of the financial system.

Along a similar vein, our findings are supportive of the idea that climate awareness on the lender’s side is a prerequisite for the greening of bank lending. This has been recognized in the public discourse on climate transition. For example, in 2021 Euromoney, a magazine on financial markets, selected BNP Paribas, who is a UNEP FI member, as winner of its “best bank for ESG data and technology 2021”, and praises that “the French bank put data at the heart of its sustainable finance strategy and devoted substantial resources to developing its data collection and processing capabilities”. This is a recognition of the fact that investment in technology, data and expertise on climate risk is an essential part of the transition process.

Lastly, countries with a bank-based financial system could stimulate the greening of their economy through further development of the conventional equity markets (De Haas and Popov, 2019). More broadly, the authors suggest that mandating an environmental objective for a European Capital Market Union might foster sustainable equity-based growth. Deepening stock markets by, for instance, re-assessing the tax shield on debt or by removing other obstacles that hamper equity-based investment, might promote the funding of low-carbon infrastructure and other climate solutions, and ultimately scale-up green investment.

Coordinated climate policy action

Climate change presents a global challenge and therefore requires a global coordinated policy response. While G20 leaders seek to strengthen their climate policies in support of the Paris Agreement, one issue that will undoubtedly come to play is the (lack of) coordination among policies implemented across different jurisdictions. For example, Benincasa et al. (2021) analyse whether banks exploit cross-country heterogeneity in climate policy stringency as a regulatory arbitrage tool. More specifically, investigating whether banks use cross-border lending to react to higher climate policy stringency in their home countries, the authors find that banks do indeed react to greater climate policy stringency in their home country by increasing their cross-border lending. This suggests that a lack of homogeneity and coordination in the regulations for climate change can reduce the effectiveness of such regulations through a bank lending channel.

Likewise, considering carbon taxes, Laeven and Popov (2021) show that after the introduction of a carbon tax, banks reallocate a large share of their fossil loan portfolio to countries without a carbon tax. This suggests that banks effectively shift carbon emissions across national borders to circumvent a negative impact of a carbon tax. This emphasizes the need for global policy coordination so as to mitigate the potential for regulatory arbitrage and improve the effectiveness of climate policy. Moreover, it acknowledges the need for policymakers to cooperate and assess the potential cross-border effects of policy measures adopted by national authorities in to order to allow cross-border authorities to respond by adopting suitable reciprocating measures. Nevertheless, we should reiterate the high value in taking coordinated actions to accelerate cooperative climate action in line with the objectives of the Paris Agreement.

 

4. Conclusion

Climate change risks are now in the focus of both public and political attention. The goals of the Paris Climate Agreement have provided governments, regulators and financial institutions with a roadmap for climate actions that will reduce emissions and build climate resilience. By directing financial flows towards sustainable activities and integrating environmental considerations into the investment process, the financial sector has great potential to shape sustainable economic systems.

In our paper, we explore whether green attitudes by firms as well as banks are reflected in the pricing of (syndicated) bank credit. Our findings, both empirically and theoretically, confirm that green attitudes are considered in pricing conditions in a significant way, and this was largely emanated following the adoption of the Paris Agreement. Specifically, we find that firms showing environmental consciousness in the form of voluntary climate-related disclosure enjoy more favourable terms of about 50 bps compared to other firms when borrowing from a consortium of green banks. This suggests that green banks have incentives to pursue third-degree price discrimination between green firms and other firms when the awareness of green transition risks is sufficiently high. These findings indicate that mandating climate-related financial disclosure and stimulating green bank initiatives can stimulate a market-based process of sustainable resource allocation and set the world on a path that should eventually avoid dangerous climate change effects.

 

References

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Berg, F., Koelbel, J.F., and Rigobon, R. (2019). Aggregate confusion: The divergence of ESG ratings. MIT Sloan School of Management.

Bernstein, A., Gustafson, M. T., and Lewis, R. (2019). Disaster on the horizon: The price effect of sea level rise. Journal of Financial Economics, 134: 253–72.

Bolton, P., and Kacperczyk, M. (2021). Do Investors Care About Carbon Risk? Journal of Financial Economics, 142(2): 517-549.

Chava, S. (2014). Environmental Externalities and Cost of Capital. Management Science, 60 (9): 2223-2247.

De Haas, R., and Popov, A. (2019). Finance and Carbon Emissions. ECB Working Paper Series No. 2318.

Degryse, H., Goncharenko, R., Theunisz, C., and Vadasz, T. (2021). When Green Meets Green. CEPR Discussion Paper DP16536.

Degryse, H., Roukny, T., and Tielens, J. (2020). Banking Barriers to the Green Economy. NBB Working Paper Research No. 391.

Delis, M., 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 Series No. 18-10.

Ehlers, T., Packer, F., and de Greiff, K. (2021). The Pricing of Carbon Risk in Syndicated Loans: Which Risks are Priced and Why? Journal of Banking and Finance, forthcoming.

Fatica, S., Panzica, R., and Rancan, M. (2019). The Pricing of Green Bonds: Are Financial Institutions Special? JRC Working Papers in Economics and Finance.

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Kleimeier, S., and Viehs, M. (2018). Carbon Disclosure, Emission Levels, and the Cost of Debt. SSRN Working Paper.

Krueger, P., Sautner, Z., and Starks, L. T. (2020). The Importance of Climate Risks for Institutional Investors. Review of Financial Studies, 33(3): 1067–111.

Laeven, L., and Popov, A. (2021). Carbon Taxes and the Geography of Fossil Lending. CEPR DP16745

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Authors

Alessandro Giovannini^[1]European Central Bank. and Fabio Tamburrini^[2]European Central Bank.

 

Sustainable finance, broadly defined as the integration of environmental, social and governance (ESG) aspects into financial decision-making, has grown rapidly in recent years (ECB, 2020). From a niche market for specialized investors, it has become mainstream, driven not only by top-down initiatives by financial institutions and corporates, but also by a growing and genuine demand from investors (Panetta, 2020).

The pace of growth of this market is only matched by the proliferation of government policies in this area. The UN Agenda for Sustainable Development and Paris agreement contributed significantly to this process: in particular the international commitment to “making financial flows consistent with a pathway towards low greenhouse gas emissions and climate resilient development” has prompted policymakers to see sustainable finance as a key policy tool to mobilise and shift financial flows, to support, or even catalyse the transition to a low-carbon economy (Thimann, 2019). The European Union has notably been leading the way internationally in regulating sustainable finance (European Commission, 2018), but initiatives have rapidly expanded globally to promote the growth and integrity of this market and formally integrate sustainability into financial decision making (Panetta, 2021).

These trends point to a broad consensus over the desirability, or even the necessity of sustainable finance; yet the burgeoning new industry and the growing corpus of regulatory measures remain surrounded by a general ambiguity as regards the specific objectives they pursue, the mechanics of how they are supposed to achieve such goals, and the evidence over their concrete effectiveness.

This article argues that a clearer and more rigorous examination of this new area of finance is needed. A deeper understanding of sustainable finance is essential to design effective public policies, guide efficient private investment decisions, as well as to obtain a balanced assessment of the role of sustainable finance among the broader toolkit to achieve the transition to a sustainable economy. The discussion is structured along three key questions: (i) what is the aim of sustainable finance? (ii) How is sustainable finance supposed to work? (iii) Does sustainable finance actually work in practice?

 

What is the objective of sustainable finance?

A former investment banker and private equity professional once said “sustainable investing is a confusing area of finance that often means different things to different people” (Fancy, 2021). A closer look at the relevant literature, at the policy debate and the advertisements by investment professionals shows that they have not only been using different terminologies, but they also approach the field from different perspectives. The latter – although loosely associated – betray at close inspection a fundamental lack of consensus over the purposes of sustainable finance

This lack of consensus is arguably the key obstacle to the development of a coherent conceptual understanding and to deeper analysis of sustainable finance, which in turn generates confusion or even scepticism about the merits of sustainable finance, harming the credibility of the nascent market (Migliorelli, 2021).

To begin with, it is therefore essential to shed light on the motivations of sustainable finance, in other words, what are the objectives that sustainable finance is set to achieve? While numerous such typologies have been proposed (Busch et al., 2021), a minimal classification should distinguish between three main approaches, based on the main objectives each of them pursues.

1. The first approach’s main motivation is to align investments with ethical preferences: under this model, which has arguably been the first one to appear historically (Busch et al., 2021), sustainable finance can be conceived as a tool to screen and adjust portfolios to better match the moral preferences of the investor, based on selective exclusions or penalisation of “undesirable”, “unethical” or “unsustainable” activities. Investment decisions are guided by non-monetary motives: the investor’s utility function is thus multidimensional, with utility derived not only by the risk-adjusted returns, but also by non-pecuniary rewards, such as consistency with the investor’s value system. In this approach, what matters is the subjective motive of the investor: any real impact of these investment decisions, e.g. any effect on businesses’ incentives and actions, is not the prime objective, but rather a (potential) by-product of investment decisions that maximise subjective utility.

2. A second approach sees sustainable finance as an enhancement of conventional financial decision-making: its stylised goal is to better capture financial risks associated to non-sustainable business activities which conventional finance is unable to detect. This model does not depart from the conventional financial motive of maximising returns: it carries instead the promise of combining ethical, social and environmental purposes with the traditional financial motive of maximising returns. Under this framework investors take into account ESG aspects in addition to conventional financial metrics, because this information is financially material and is considered to improve investment performance in the long-term (Amel-Zadeh & Serafeim, 2018). In this approach, individual self-interest and societal goals are not in contradiction, and no trade-off exists between the pursuit of financial returns and the achievement of desirable societal goals.

3. Finally, a third approach – which is arguably predominant among policy-makers – sees the primary purpose of sustainable finance as to produce real-world changes, e.g. solving social challenges and/or mitigating ecological degradation. Under this framework, sustainable finance is at the service of society at large. The underlying objective is not the monetary rewards of individuals, but the broader mitigation of sustainability risks for society. Individual investors do not only aim to maximise individual utility, but also social welfare. To this end, investors are willing to forego part of their returns or take greater financial risks in order to generate positive impacts on the society at large (Brest & Born, 2013).

 

How is sustainable finance supposed to work?

These various conceptual frameworks are not mutually exclusive and often coexist to some degree in investors’ motivations or in the products offered by the industry. Their different focus affects the specific investment strategy adopted. Numerous typologies of such strategies exist. Seven main strategies can be broadly defined (GSIA, 2017): (a) negative/exclusionary screening; (b) positive/best-in-class screening; (c) norms-based screening; (d) integration of ESG factors; (e) sustainability themed investing; (f) impact investing; (g) corporate engagement and shareholder action.

Linking these strategies to the motivations discussed in the previous section, it emerges that exclusionary approaches (a to c) are particularly common among ethically motivated investors. ESG integration (d) or best-in-class approaches (b) is the dominant approach for those investors that see sustainability as enhancing investment performance. Impact investment and corporate engagement (f and g) put an emphasis on real world impact.
Yet, a rigorous analysis needs to go beyond acknowledging the coexistence of different motivations and investment strategies. These different approaches imply entirely different theories of change of corporate behaviour that are underpinned by contradictory assumptions over how sustainable finance is supposed to achieve its goals.

Perhaps the most striking contradiction involves the role of returns.
If the purpose of sustainable finance as to produce real-world changes, then portfolio adjustments or divestments of unsustainable activities should lead to a higher cost of capital for unsustainable companies, either via change stock prices (and the cost of external capital more broadly), or through the reputational impact that divestment announcements can make (Heinkel et al., 2001). The higher cost of capital should, in turn, incentivise corporates to move away from unsustainable activities (Pastor et al., 2021). As such, sustainable investors should be willing to forego part of their finacial returns for societal goods.

This theory of change is inconsistent with the alternative view that ESG investing improves financial performance, by providing investors with material information over the long-term financial performance of a company and thus leading to outperformance of ESG investments over conventional ones. In this model, sustainable firms perform better financially regardless of the action of sustainable investors, and sustainable investing simply reflects this intrinsic outperformance (Friede at al., 2015). In this framework, being sustainable in itself delivers financial rewards for the company, without the need for the investor to step in to provide the extra incentive. ESG investors simply reap the benefits of companies’ self-interested sustainable behaviour. This is in contradiction with impact-oriented approaches, where sustainable behaviour emerges as a result of sustainable investors’ willingness to forego part of their returns, thus reducing the cost of capital for sustainable activities.

These two approaches are in antithesis: if the former approach is correct, and ESG investment improves financial returns, then the latter is wrong, and sustainable finance cannot affect companies’ financial incentives and produce meaningful real-world impact. While different actors may well adopt one or the other, and the two may coexist in the industry as a reflection of different understandings and assumptions by users, logically they are mutually exclusive approaches that cannot be held as valid at the same time.

 

What is the evidence of sustainable finance?

Whether the different approaches outlined above work in practice, and which one best delivers on its intended goals, could be ultimately set by empirical investigations. Yet, the confusion existing over the various conceptual frameworks of sustainable finance, has also affected the empirical analysis conducted so far. While a large and growing literature has looked at the relative financial performance of sustainable investments over conventional or unsustainable ones, little is known about the impact of sustainable finance on companies’ decisions, its channels, and their magnitudes. To date the vast majority of studies uses ESG metrics as an explanatory variable and only very few have analyzed ESG metrics as a dependent variable, leaving the following two fundamental questions unanswered (Kölbel et al., 2020). First, if there is no agreement on the size of the effect sustainable investors have on asset prices, how can we sure about the material effect of sustainable finance? Second, even in the presence of evidence that the capital allocation of sustainable investors has affected asset prices, is there evidence that such changes in asset prices have translated into changes in ESG practices by the companies?

This literature gap is striking and worrying, calling for further research. In the absence of the latter, the question whether sustainable finance is capable of delivering on the high public expectations which the industry and the public sector have put on it remains still unanswered. The absence of such research negatively impacts on the ability to design effective public policies to promote sustainable finance able to address societal challenges.

 

Conclusions

Coherently answering what sustainable finance is, how it works and whether it concretely delivers, is of the essence for a clearer debate on the government policy and regulatory initiatives needed to make it work. The current confusion and lack of a clear conceptual understanding of sustainable finance, on the contrary, risks limiting its development, triggering public scepticism over sustainable finance and ultimately hindering its transformative potential. It could, in fact, lead to the opposite, giving a false sense of hope that the dramatic growth of sustainable finance will be able – alone – to make the necessary adjustments in our economy to meet the major challenges of climate change and sustainable development. If we fail, there is a real risk that sustainable finance is merely a placebo that ultimately harms public interest (Fancy, 2021).

 

References:

Amel-Zadeh, A., and Serafeim, G. (2018). Why and How Investors Use ESG Information: Evidence from a Global Survey. Financial Analysts Journal, 74(3): 87-103

Brest P., and Born, K. (2013). When can impact investing create real impact. Stanford Social Innovation Review, 11(4): 22-31.

Busch, T., Bruce-Clark, P., Derwall, J., Eccles, R., Hebb, T., Hoepner, A., … and Weber, O. (2021). Impact investments: a call for (re) orientation. SN Business & Economics, 1(2), 1-13.

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Kölbel, J.F., Heeb, F., Paetzold, F., and Busch, T. (2020). Can sustainable investing save the world? Reviewing the mechanisms of investor impact. Organization & Environment, 33 (4): 554-574.

Migliorelli, M. (2021). What Do We Mean by Sustainable Finance? Assessing Existing Frameworks and Policy Risks. Sustainability, 13, 975.

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Panetta, F. (2021). A Global Accord for Sustainable Finance. Op. Ed Project Syndicate.

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Thimann, Ch. (2019). Finance and sustainability: the end of “business as usual”, BaFin Perspectives, Issue 2 2019.