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Regulators rule on climate risk

Past Managing Editor, bluenotes

2021-02-24 09:53

The return of science and evidence-based policy in the US since the demise of the Trump Court is occurring not just on the headline front – like rejoining the Paris accord on climate change – but in some of the more fundamental sectors of the economy, notably financial services.

As banking and insurance regulators around the world have increasingly called for their charges to properly interrogate climate change across all risk categories, including credit and operational, US regulators had been relatively low-key under Trump.

"Climate change is already imposing substantial economic costs and is projected to have a profound effect on the economy at home and abroad.” – Lael Brainard

That is now changing. Lael Brainard, a member of the Board of Governors of the Federal Reserve System, gave a recent speech “The role of financial institutions in tackling the challenges of climate change” laying out the parameters from the Fed’s perspective.

She was joined by representatives of the Securities and Exchange Commission (SEC) and the US Commodity Futures Trading Commission (CFTC). The SEC’s John Coates was blunt: “Personally I’m going to do my part to help the SEC policy keep pace with developments that are affecting investors and public companies and capital markets…  And in case anybody had any doubts [that] means respecting science and evidence and reality.”

Rostin Behnam, acting chairman of the CFTC said he was looking to “narrow the focus on what the CFTC can do” to support carbon markets and the transition to a low-carbon economy. This is not just a domestic return to rationality.

Any shift by the US is particularly significant given the outsize role it plays in the global economy, the reserve currency status of the greenback and US’s willingness to project its regulatory imposts beyond its own borders, whether that be sanctions or securities regulation or tax.

In her address Brainard emphasised the leading roll the financial sector and markets needed to play to affect a meaningful response to the existential risk of climate change.

She opened unequivocally: “Climate change is already imposing substantial economic costs and is projected to have a profound effect on the economy at home and abroad.”

“Financial institutions that do not put in place frameworks to measure, monitor, and manage climate-related risks could face outsized losses on climate-sensitive assets caused by environmental shifts, by a disorderly transition to a low-carbon economy, or by a combination of both,” Brainard said.

“Conversely, robust risk management, scenario analysis, and forward planning can help ensure financial institutions are resilient to climate-related risks and well-positioned to support the transition to a more sustainable economy.”

Existing mandate

This is exactly the position of regulators of all major economies, including Australia, and focuses on the systemic risk to the financial sector. As Brainard said: “A recent survey of central banks found a large majority view it as appropriate ‘to act within their existing mandate to mitigate climate-related financial risks’ that ‘could potentially impact the safety and soundness of individual financial institutions and could pose potential financial stability concerns’ for the financial system.”

On this front Brainard is essentially articulating a position which brings the US back into line with other sentient regulatory regimes, emphasising the global nature of the challenge and the need for collaboration. Where she went forward was in outlining some of the approaches and tools central banks are considering, including long term scenario analysis – as opposed to the current model of stress-testing banks with a focus on liquidity and capital in short run scenarios.

“To be clear, scenario analysis is distinct from our traditional regulatory stress tests at banks,” she said. “Scenario analysis is an exploratory exercise that allows banks and supervisors to assess business model resilience to a range of long-run scenarios.”

Particularly notable, for those institutions which also see opportunity in emerging markets such as green financing and renewable energy, was Brainard’s consistent reference to risk and opportunity – including in cahoots with regulators.

“In wrestling with the many complexities and challenges related to climate change, there are likely to be significant opportunities for collaboration with the private and official sectors,” she said.

Willingness to act

Private institutions and the corporate sector are already demonstrating a willingness to act ahead of government policy and this commitment will be bolstered by regulatory impetus.

And there are plenty of opportunities. We are already seeing markets factoring in a funding advantage for debt with credible green credentials.

Meanwhile, markets in abatement measures such as carbon credits are developing and, according to McKinsey & Co, can play a dual role:

  • In the short-term, voluntary carbon credits from projects focused on emissions avoidance/reduction can help accelerate the transition to a decarbonised global economy, for example by driving investment into renewable energy, energy efficiency, and natural capital. Avoiding emissions is typically the most cost-efficient way to address atmospheric greenhouse gas concentrations.
  • In the medium- to long-term, voluntary carbon credits could play an important role in scaling up carbon dioxide removals (or negative emissions) needed to neutralise residual emissions.

Such markets are operating even where they are only voluntary as a growing number of organisations look to be more pro-active.

The market however, even though the trends are positive, will not be sufficient.

According to the European Central Bank executive Fabio Panetta, implementing a net zero emissions agenda by 2030 will require total investment of between $US5 to 7 trillion per year.

“Whether investment programs of this scale can be implemented will largely depend on the cost and availability of financial resources,” he noted. “The lower cost of capital compared with traditional investments – also referred to as the green premium – could encourage the launch of new sustainable projects.

“However, empirical analyses show that this premium would be small at best. It is therefore unrealistic to imagine that the huge volume of investment needed to ensure sustainable development can take place without the involvement of the public sector, for example in order to raise the price of coal by strengthening the emissions trading system or to support research and development of alternative energy sources.”

Sustainable bond issuance will grow by 32 per cent to $US650 billion globally this year, according to Moody’s Investors Service - double the $US324 billion level of two years ago but still vastly short of the funding requirement.

Yet at the market level the trends are incontrovertible. Banks and other providers of risk capital have limited resources; decisions on where to deploy that capital are based on risk-adjusted returns on equity; those risks include not just market (prices) and credit (for example, the inevitability of stranded assets); but also operational risk – notably the actions of regulators to steer investment towards a reduction of carbon emissions to reduce the systemic risk to the financial system.

That’s a pretty clear outlook even if the detail and timing remain uncertain.

Andrew Cornell is Managing Editor of bluenotes

The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.

anzcomau:Bluenotes/Environment,anzcomau:Bluenotes/social-and-economic-sustainability,anzcomau:Bluenotes/Regulation
Regulators rule on climate risk
Andrew Cornell
Past Managing Editor, bluenotes
2021-02-24
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