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Seeing green: how regulation can help markets manage climate risk

01 December, 2020Ouida Taaffe

Financial services firms decide where investment goes. If the future economy is to be green, banking and finance will need to make environmentally sustainable investments. But to do that they have to be able to know which assets are – and will continue to – benefit the environment. The UK regulator is setting out to help them find the way to a green economy.

Melting ice capsAudrey Choi, Chief Sustainability Officer at Morgan Stanley said at the Green Horizon Summit in November: “You can’t manage to something if you don’t have metrics…[You need] a commonly agreed upon, business useful way of [tracking] carbon emissions.”

But a recent Sustainable Financing and Investing Survey by HSBC found that only 35% of investors disclosed the ESG characteristics of their whole portfolio. 

To try to ensure that its financial system will be resilient to climate change risk – and supports the transition to a net-zero economy – the UK government announced on 9 November that, from 2025, all financial disclosures across the UK will have to be aligned with the standards of the Financial Stability Board’s Task Force on Climate-Related Financial Disclosures (TCFD).

The UK is the first country to make that requirement.

The thinking behind the TCFD is that continued warming of the Earth will likely lead to “catastrophic” economic and social changes. To make it possible for firms to help avoid that, the TCFD wants financial markets to have “clear, comprehensive, high-quality information on the impacts of climate change”.

Climate risk is financial risk 

Climate change poses many risks, but one that can be overlooked in headlines is the risk to financial stability. That is why the Bank of England is also going to launch climate stress tests for financial services firms in June 2021.

The central bank first announced the plan in July 2019. It was put on the back burner when the Covid-19 crisis hit to give firms and the bank itself enough time to prepare.

Andrew Bailey, Governor of the Bank of England, said the stress tests will look at three different climate scenarios. He added that the aim is to test “different combinations of physical and transition risks over a 30-year period”.

Sustainability is a global challenge

Bailey also highlighted that “climate is a common global risk and we cannot hope to insulate ourselves through domestic action alone”.

As part of its global work on climate change, the UK is a co-founder of the Central Banks and Supervisors Network for Greening the Financial System (NGFS).

The world has a clear target on what the upper limit of global warming should be. In 2015, the so-called Paris agreement set out to hold “the increase in the global average temperature to well below 2°C above pre-industrial levels and to pursue efforts to limit the temperature increase to 1.5°C above pre-industrial levels”.

There is, however, no universal basic level of understanding of environmental risks in the global financial community, according to the NGFS.

One of the problems, the NGFS says, is the “lack of clear definitions of green and brown assets…[and the] lack of user friendly environmental and climate data”.

How do investors know what’s green and what’s not?

To help investors know what’s green and what’s not, the UK has introduced a “green taxonomy” – a way of clearly labelling assets.

The UK taxonomy will be based on the scientific metrics in the EU taxonomy. But the UK is also setting up a Green Technical Advisory Group to review the metrics.

Rigour will be important in this. Morgan Stanley’s Choi says, “It cannot be an interpretative dance. It has to be based on data and science….[you] have to have globally accepted parameters; where to companies rate in relation to that benchmark. Until we have, that is more of a hand-waving exercise.”

She is, however, optimistic that sustainable finance is gaining ground. Sustainable investment strategies have recently been outperforming traditional approaches.

Choi says, “Five or ten years ago, [focusing on climate change] was more about mission alignment change. Now, it’s material to risk.”

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