It’s been a record year for green bonds. Mainstream investors are shifting to sustainable assets. So how can good news on green finance be bad news for the planet? Because we’re still not seeing the capital flows required for the transition to a low-carbon, resilient and inclusive economy.
Here, the Blended Finance Taskforce explains the changes that investors need to see in 2020 to accelerate and scale investments in low-carbon assets.
Earlier this year, an alliance of the world’s largest pension funds and insurers, managing $2.4 trillion in investments, committed to achieving carbon-neutral investment portfolios by 2050. It’s just one example of an increased ambition to shift portfolios towards low-carbon, sustainable assets.
The shift goes beyond commitments and targets. 2019 was yet another record year for green bonds, and acquisitions of climate risk analytics and impact investment boutiques from mainstream investors - such as 427, bought by Moody’s, and Schroders acquiring a majority stake in BlueOrchard - signalled a definite rise in sustainable finance practices.
Policymakers and regulators have also been driving the increased investor action through disclosure initiatives like the “Task Force on Climate-related Financial Disclosure” (TCFD), and regulatory frameworks on green standards and taxonomies including the European Commission’s “Action Plan on Financing Sustainable Growth” and China’s early “Guidelines for establishing the green financial system”. We have also seen a recent push by central banks, recognising climate-related risks as material to financial stability and collaborating through “Network for Greening the Financial System” (NGFS).
But it’s not enough. We are still not seeing capital flow at the speed or scale that is required to equip companies and countries to combat the effects of climate change. The green bond market is only 0.2% of the overall debt market. Meanwhile fossil fuel bank financing has been rising since 2015 and carbon emissions climbed by 2% in 2018 (the fastest year since 2011) because of high energy demand delivered by fossil fuels.
Bad macro- and sectoral policies are the main factors leading to capital misallocation: the lack of a carbon price, fossil fuel and distorting agricultural subsidies, and regulatory and planning failures. However, there are important impediments in the capital markets. They relate to their structure and conduct driven by financial system regulation, information asymmetries, investor inertia and product supply. Some of these barriers restrict domestic investment, while others restrict cross-border investment.
How can we address the structural barriers that act as a brake, rather than an accelerator of the transition we need? And how are regulators and market participants already addressing these barriers?
REGULATORS AND CENTRAL BANKS ARE NOT FULLY USING THEIR TOOL-BOX TO INCENTIVISE CLIMATE-ALIGNED INVESTMENT
Many of the regulatory requirements on liquidity, reserves and capital provisioning were introduced or tightened after the global financial crisis to safeguard the stability of the financial system. However, these measures tend to restrict the flexibility of banks (Basel III) and insurers (Solvency II in Europe) to invest in the low carbon economy, as they create hurdles to invest in infrastructure and/or emerging markets.
Basel III has contributed to a decline in cross-border lending after the 2007-08 financial crisis (alongside deleveraging processes and tougher standards for anti-money laundering). It is often cited as a disincentive to investing in emerging markets and infrastructure, owing to biases that favour corporate bond issuance (which helps the oil and gas companies that are major issuers of these bonds) over infrastructure finance.
Differentiated capital weighting could help: by assigning higher or lower risk weights depending on sustainability criteria and carbon-intensity in anticipation of future negative and sudden price developments.
The French and Italian Banking Associations have called for a “green supporting factor” in response to the European Commission’s Action Plan on Sustainable Finance. And while the People’s Bank of China has announced it will integrate “green finance” into its macro-prudential assessment framework, the European Commission and the NGFS have committed to carrying out more research to assess risk differentials between green and brown assets.
One key area of work will be on risk assessment frameworks. These are currently backward-looking and therefore do not adequately capture climate-related risks, which require more sophisticated forward-looking analysis and longer time horizons.
Quantitative easing by central banks, in the US and Europe, has also been charged with being unsupportive of investments in the low-carbon economy. The asset-purchasing programme entailed buying high-quality, liquid assets in the form of government and corporate bonds that reflect the overall market; this inevitably means issuers are more often in high-carbon industries than low-carbon ones.
Some have argued that these programmes have indirectly favoured the growth of high-carbon incumbent industries by providing them with cheaper financing – thereby negating the “market-neutral” approach warranted by central banks. This has led to calls for a review of the impact of monetary policy on real assets.
Others are also calling for central banks to manage their own assets according to responsible investment standards, or at least manage their pension funds according to sustainable metrics.
LACK OF CLARITY ON FIDUCIARY DUTY AND OUTDATED INTERPRETATIONS OF LEGAL OBLIGATIONS
Institutional investors often justify inaction on climate by citing their fiduciary duty to maximise returns. Their ability to factor in non-financial metrics - in relation to climate, for example - and to take longer-term views remains unclear or secondary.
This affects how asset managers execute their investment mandates. They are rewarded on the wrong metrics in an increasingly competitive, low-fee, passive investing environment, typically leading to short-term performance bias. The lack of clarity around the scope of fiduciary duty and existing loopholes can further reinforce the old mindset: that taking non-financial metrics into account when assessing portfolio opportunities reduces the investable universe and risks limiting returns.
SHORT-TERMISM AND MISMATCH OF TIME HORIZONS
For most asset managers and owners, climate issues are still not considered material and do not feature in short-term investment decisions.
Capital markets are supposed to look to future cash-flows, but the combination of discounting methodologies, short-term incentives and the unfamiliar, non-linear nature of climate-related risks makes it almost inevitable that - without strong regulation - market actors respond only when it is too late. The ability of cash-rich, carbon-intensive incumbents to reward financial intermediaries with rich fees only compounds the problem.
Beyond the role of high-frequency trading, financial institutions such as hedge funds with short time horizons, and the structure of performance-based financial reward in the financial industry, regulations can also encourage short-term investment behaviours. For example, mark-to-market accounting rules for assets held in long-term portfolios, pro-cyclical prudential regulation and quarterly financial performance reporting can drive short-term biases.
This has also meant favouring investment in financial assets over productive assets from companies: between 1980 and 2006, Fortune 500 companies spent around 2.5x in share repurchases compared to R&D investments.
Many high-profile investors and corporate leaders are joining forces to stop pressure from quarterly earnings to drive more long-term decision making. For example, JP Morgan CEO Jamie Dimon, and Warren Buffett have teamed up for this cause, arguing that companies will pursue activities that are counter to the long-term interests of the business as long as executives and investors are focused on the short term. However, it is less clear that these pronouncements from Buffett and Dimon change the investment conduct of their institutions.
THE CHALLENGING INVESTMENT CHARACTERISTICS OF LOW-CARBON ASSETS
It is challenging for investors to invest in newer, asset-light climate and technology-driven solutions due to high perceived risks driven by geography, high upfront costs, or untested business models and lack of historical performance data.
This is especially true in emerging markets where capital is needed most. Clean-tech innovation plays are even more challenging. They are more capital-intensive than, for example, the next social media app. As a result, they suffer from deep “valley of death” financing barriers as they move beyond the demonstration phase.
One way to address the challenges of investing in the low-carbon economy is to generate investable products for institutional investors, through aggregation and other de-risking measures: policy support, innovative public-private partnerships or blended finance platforms. Examples include the Property Assessed Clean Energy (PACE) Program for energy-efficiency projects; Fannie Mae’s $50 billion green mortgage-backed securities programme; and the former UK Green Investment Bank’s first offshore wind fund, exceeding its investment target of £1 billion (US$1.3 billion), opening the sector to long-term investors such as pension funds. For other innovative infrastructure delivery models, see our work on Infra 3.0.
LACK OF SUPPORTING “SUSTAINABLE” MARKET INFRASTRUCTURE
With growing volumes of “ESG”, “sustainable”, “impact”, “green” and “ethical” products on the market, it’s not easy for investors to navigate the shades of green versus brown.
Asset managers have been able to label funds and define their investment processes as they see fit, making it challenging to compare products. In a low-fee and increasingly passive strategy environment, asset managers and investment consultants have incentives to stick with the creation of more conventional products and indices with an established track-record instead of pushing the boundaries for more positive underlying impact of its products.
The industry has relied on voluntary commitments, without a true standardisation of practices. The EU’s efforts to implement a taxonomy and regulation for low-carbon benchmarks will be a huge step forward in this respect, which hopefully will be harmonised across more geographies.
In June 2019, the Technical Expert Group on Sustainable Finance’s Taxonomy report effectively listed activities that are considered sustainable for mitigation and adaptation, which eventually will be transformed into policy by the EU, accompanied by a green bond standard, eco fund labels and low-carbon benchmarks. The investment association (IA) is consulting on creating standard definitions for terms and will also develop a label for funds that have adopted ethical, responsible and sustainable investment strategies, so investors can identify them more easily.
Other more “traditional” products are also limited in emerging markets, preventing capital from flowing across borders, such as long-dated foreign exchange hedging instruments or sufficiently developed bond markets that enable price discovery (e.g. green bond issuance in local currency).
A FINAL, BUT CRITICAL, GAP IS THE AVAILABILITY OF HIGH-QUALITY DATA AROUND PHYSICAL CLIMATE RISK.
Investors are slowly getting sensitized to these risks – for example, through rising insurance claims in the context of more intense hurricane seasons and, perhaps more powerfully, through the recent PG&E bankruptcy.
The PG&E case, in which a state utility is being held responsible for major property losses as a result of the wildfires in California, could be a game-changer in terms of investor awareness and a willingness to price physical climate risk.
This could affect multiple economic sectors, from real estate through agriculture, to the energy system, to global supply chains which have bottlenecks in climate-exposed geographies. Sovereign risk ratings are also likely to be affected, affecting bond prices in many markets. Financial information providers such as Moody’s/S&P are ramping up efforts in this area, alongside some new specialised players such as Jupiter, with deep data analytics skills bridging climate science and asset valuations.
LIMITED FISCAL INCENTIVES
Regulations, tax systems and climate policies need to reflect and incentivise investors to be able to make the right decisions in uncharted territory.
The rulebook must favour innovation, and incentives need to be aligned for generated profits to be re-invested in climate-positive and real value-add projects.
These changes will require political courage, which is increasingly getting backing through “greener” election results and public outcry through demonstrations.
Fiscal policy at the real asset level would have more impact and affect the pricing of related financial investments, including introducing a meaningful carbon pricing and phasing out fossil fuels. Other incentives could include tariffs and exemptions for water supply, tax breaks for geographical diversification of farming, and exemptions from land use fees for road and rail infrastructure.
PRIORITY ACTIONS FOR CAPITAL MARKETS REFORM
Capital markets have a major role to play in facilitating an orderly low-carbon transition and ensuring investment flows at the speed and scale required. This can be achieved by focusing on capital market reforms and initiatives that:
1. Measure and manage climate-related and other other nature-related financial risks through disclosure efforts and risk assessment methodologies that incorporate forward-looking, non-linear risks and longer-term horizons.
2. Clarify fiduciary duty with a clear mandate around long-term profitability of investments and relevant climate/sustainability risks to empower investment advisers to provide longer-term sustainable investment advice
3. Develop blended capital market vehicles to de-risk investments into: (i) large-scale clean energy infrastructure, especially cross-border investments into emerging markets; (ii) clean-tech to get over the “valley of death”; and (iii) more efficient buildings.
With a background in sustainable debt finance, Diletta Giuliani is part of the Blended Finance Taskforce, working to shift the financial system to more sustainable practices and accelerate investment in priority economic systems, with a focus on natural solutions.