The Financial Climate Has Reached a Tipping Point

The Covid-19 pandemic is sharpening financial markets’ understanding of the need to address looming threats like climate change. This will likely be the year when investors and financiers decide to mainstream climate-transition analysis in their portfolios. Policymakers must recognize that markets are moving far faster than they are on this critical front.

This year, we have witnessed the biggest shock to the oil and gas market in 70 years. By the end of July, traditional oil and gas shares in the S&P 500 had fallen by 45%, Royal Dutch Shell had cut its dividend for the first time since World War II, and BP had written off $17.5 billion from the value of its assets. At the same time, clean-energy stocks had risen by just over 20%, roughly the same as the tech sector.

Disruption is a powerful incentive for investors and companies to reallocate capital. The sharp decline in energy prices has accelerated concerns about worthless “stranded assets” on companies’ books. A theoretical possibility has become a plausible scenario. Financiers are re-appraising their portfolios and weighing up the risks associated with a climate transition. So far, the key concern has been that green policies will work only if investors re-price the cost of capital for different firms.

There has also been significant progress on data and measurement, which is necessary for turning corporate climate talk into action and mobilizing capital at scale. Investors, lenders, and insurers have hitherto lacked a clear view of how companies will fare as the planet warms, regulations evolve, new technologies emerge, and consumer behavior shifts. Without this information, financial markets cannot price climate-related risks and opportunities effectively. Simply put, if you can’t measure it, you can’t risk-manage it.

The Financial Stability Board’s Task Force on Climate-related Financial Disclosures (TCFD), which was spearheaded in 2015 by Mark Carney, then the governor of the Bank of England (BoE), has been producing workable standards. Today, TCFD standards have been adopted voluntarily by more than 1,000 companies – including most global financial institutions – and thus are becoming the default norm.

In fact, we have probably reached the tipping point beyond which TCFD standards will win the day. Even though there has yet to be any regulatory push, a growing number of asset owners and their managers are pressing companies to report on these standards. The $400 billion Canada Pension Plan Investment Board is merely the latest giant institution to tie its investments to both TCFD and Sustainability Accounting Standards Board standards. And the activist investor Chris Hohn has declared that his fund will press asset owners to fire fund managers who do not insist on climate transparency.

Another encouraging development is that competing standard-setting bodies, anxious that they will miss out on becoming the source of industry benchmarks, are starting to collaborate. As more jurisdictions move to codify new standards, those that do not risk becoming irrelevant. Similarly, the top data-analytics firms and index providers are buying or building capabilities to help investors fashion more climate-aware portfolios along the same general standards. As the cacophony of competing standards subsides, more financial-market participants will follow.

But data alone is no panacea. Measuring and assessing long-term trends and the interactions between climate science, public policy, economics, and financial markets is a complex undertaking. In a world of interconnected global supply chains and intersecting legal, regulatory, and operating environments, it is not easy for market participants to make sense of the potential impact of climate change and the strategic responses to it.

That is why central banks are introducing stress tests, a crucial tool for ensuring proper risk management, resilience, and transparency in the financial system. Already, 15 central banks have rolled out climate stress tests not just for banks, but also for insurers and, in some jurisdictions, pension funds.

To create a solid foundation for this process, the Central Banks and Supervisors Network for Greening the Financial System has worked with climate scientists and investors to devise three probable climate-policy scenarios. The idea is to determine whether firms are “transition ready” for a lower-carbon economy. Such tests should help to bring climate risks closer to the center of financial decision-making. But it is important to remember that central banks’ remit is limited to economic and financial resilience. They will only ever be able to offer a partial response to the broader climate challenge.

Policymakers and regulators must catch up to where markets are heading by supporting the effort to develop common “decision useful” standards. As I argued last year in the BoE’s Future of Finance report, the best solution would be to apply the TCFD framework across all financial accounts. That said, policymakers must maintain flexibility and humility to avoid hard-coding obsolete standards or creating a mountain of red tape.

Equally important will be public policies that drive a smooth climate transition, such as those proposed in the European Green Deal. So far, few governments have been willing to stick their necks out by implementing a carbon tax. Yet behind the scenes, most investors and financiers already acknowledge that such a tax would accelerate the shift to a low-carbon economy. According to Refinitiv, a carbon price of $75 per ton would cost global business around $4 trillion. As my colleague, UBS chair Axel Weber, points out, that would profoundly change incentives, possibly giving rise to a large tradable-emissions market.

Finally, to move not billions but trillions of dollars in the right direction, we need what Carney has called “50 shades of green.” No single financing model or investment position will suffice. Portfolio exclusion, engagement, and impact investing all have their uses as well as their own challenges. The most important objective is to mobilize capital, which means avoiding a set of purist rules that would overly limit the possibilities for proper portfolio diversification.

Warren Buffett’s hypothetical advice to an investor seeking to profit from the nascent car industry in 1900 – “short the horse” – is worth considering today, argues investor Ewen Cameron Watt. Successful investment is often as much about avoiding losers as picking winners. Markets are pivoting, and policymakers should take note.

The full and original article first appeared on Project Syndicate here on 23 September 2020.