The Financial System We Need

Date: 23 Oct 2015

[Re-blogged from WRI]

Ask a financial regulator or a central bank governor what role they should play on environmental issues, and most will suggest you’re talking to the wrong person.

This is changing, and will change faster after the launch this past week of UNEP’s “Inquiry into the Design of a Sustainable Financial System.” It’s a very important report, and will hopefully help launch a decade of reform in financial markets.

The job of the financial system is, of course, to intermediate between savers and investors in a manner that provides transparent and accurate information on risks and prospective returns, so that risk adjusted returns can be maximized and the economy and savers can prosper.

The recent financial crisis reminded us that financial markets, sophisticated as they are, can be rather bad at assessing and clarifying risk so that sound allocation decisions can be made. This was true of lending to high risk housing in the United States, for example. But it is much worse for environmental risk.

Consider water risk, for example. The annual World Economic Forum survey of 1,000 CEOs ranks water crises as the highest of all risks—even above another financial crisis, terrorism, etc. Surely then financial markets would have a way of assessing this risk, as they would, for example, for the risk of a global recession? Indeed, not. Until now, apart from a few pioneers, there has been an almost complete lack of attention to such environmental issues. This is also true of climate change, which followed closely behind water as a huge systemic risk in the World Economic Forum’s annual survey.

This is all now changing for the better. UNEP’s report “The Financial System We Need: Reshaping Finance for Sustainable Development” captures this emerging awareness, and urges much more rapid reform. Slowly but surely financial institutions and those who regulate them are insisting on deeper analysis and disclosure of environmental data. (Bloomberg terminals now carry WRI’s Aqueduct water risk data, for example.) Some governments are passing laws to spur progress. This year, the French government introduced legislation requiring listed companies and investors to disclose their carbon footprint and exposure to climate risks.

There’s another point. Traditionally, financial markets have underestimated environmental risks (such as that of stranded assets), but overestimated risks of new technologies (such as those for renewable energy) due to a lack of familiarity. To compensate for this, a growing number of central bankers, regulators and financial institutions are actively intervening to force a shift of financial flows into green investment. The Chinese government is a leader in this area, and in Bangladesh, for example, all banks need to allocate 5 percent of loans to “green” projects by 2016.

Emerging and developing country financial regulators are at the forefront of this movement. Innovative thinking is being driven by the countries most likely to experience the devastating impacts of climate change. Financial regulators in Brazil, Peru, South Africa, Indonesia, and Kenya are pursuing a range of initiatives to integrate finance and the environment. In 2011, Brazil’s central bank, for example, asked banks to monitor environmental risks as part of implementation of Basel III’s Internal Review for Capital Adequacy. Last year, the central bank followed that request with a requirement that all banks establish environmental and social (E&S) risk management systems.

We have seen this type of innovative leadership first-hand in our respective roles as co-chair of a green finance task force under the China Council for International Cooperation and Environment and Development (CCICED) and co-chair of the French presidential commission for innovative climate finance. In China, for example, financial leaders are already moving decisively. In 2012, the China Banking Regulatory Commission issued the Green Credit Guidelines, which, in addition to calling for stronger E&S risk management by banks, directed banks to increase their support to green sectors. Decision-makers are now actively planning to enable a green bonds market in China, and a range of other measures relating to disclosure and green finance. So, too, the Hollande Commission proposed a number of innovations to improve the efficiency and sustainability of the financial sector.

A handful of developed country regulators are also actively incorporating these concerns, particularly with respect to the impacts of climate change, into reforms of their financial systems. This month, the Bank of England’s Prudential Regulatory Authority (PRA) issued a report on “The impact of climate change on the UK insurance sector.” In his speech announcing the report, Bank of England Governor Mark Carney identified the need for better disclosure of climate risk exposure, guidance from governments on potential carbon price paths to enable valuation of climate risk exposure, and stress testing to assess the impacts of climate change on financial returns.

In just a few short weeks, negotiators will convene in Paris for final deliberations of a new international climate agreement. Much political attention will understandably focus on the annual $100 billion that has been promised by rich countries to developing countries by 2020. But much more important for long term success will be how to redirect the $90 trillion that will be invested worldwide in infrastructure over the next 15 years so that it will enhance rather than undermine sustainability. Central to success will be an awakening of financial markets to their role.

The UNEP Inquiry concludes that a “quiet revolution” is taking place globally, whereby the financial system will help drive asset allocation in the service of sustainability. The revolution will need to become a little noisier if we are to enjoy the financial system we need.