Authors: Cédric Merle, Radek Jan
“The task is large, the window of opportunity is short, and the stakes are existential”
Mark Carney, the Governor of the Bank of England (BoE), made the concluding address of the European Commission’s Conference on Sustainable Finance on 21 March 2019 in Brussels.
He delivered a compelling speech whereby he chartered the ways to open “A New Horizon” that can “break the Tragedy of the Horizon”, echoing the famous lecture he made in 2015.
Albeit taking stock of the progress achieved over the last years – “a step change in both demand and supply of climate reporting […] the endorsement of the TCFD recommendations by more than 600 organisations, with a total market capitalisation of US$9tn […] the European Commission’s Sustainable Finance Action Plan […] the three major credit rating agencies have all integrated environmental risk and green certification into credit ratings” […] “inaugural sovereign green issues from five countries last year”, he warned that “the task is large, the window of opportunity is short, and the stakes are existential.”
He insisted on the regulator and market participants’ stewardship “to develop the frameworks for markets to adjust efficiently”. Indeed, “A market in the transition to a two-degree world is being built. It will reveal how the valuations of companies could change over time as climate policies adapt and carbon intensity declines. It will expose the likely future cost of doing business, of paying for emissions, and of tighter regulation. It will help smooth price adjustments as opinions change, rather than concentrating in a climate “Minsky moment”.
The successful path towards this “New Horizon” passes through three critical areas: 1) reporting, 2) risk and 3) return related to low-carbon transition. He epitomized his thinking in a sentence poised to be remembered “The more prolific the reporting, the more robust the risk assessment and the more widespread the return optimisation, the more rapidly this transition will happen, breaking the Tragedy of the Horizon.”
The first step towards safeguarding financial stability from climate change-related risks is to ensure that the markets have access to “the right information to price climate risk and reward climate innovation”. This is why the Financial Stability Board (FSB) established the Task Force on Climate-Related Financial Disclosures (TCFD), which has garnered considerable support and endorsement. Over 600 organisations, with a total market capitalisation of US$9 trillion, have endorsed the TCFD recommendations since 2017. Nevertheless, Mark Carney calls for more progress in TCFD implementation in three areas: “1) financial implications are often not yet disclosed, 2) disclosures are often in multiple reports making comparisons harder and 3) disclosure varies by industry and region, with higher percentages of European firms and higher shares of those on the climate frontline – such as the energy sector – disclosing more information aligned with the recommendations”.
- RISK ANALYSIS
The path to “a New Horizon” necessarily passes through better climate change risk management.
He reminded that climate change results in both physical risks [which] “arise from the increased frequency and severity of climate- and weather-related events that damage property and disrupt trade”) and transition risks [which] “result from the adjustment towards a lower-carbon economy. Changes in policies, technologies and physical risks will prompt a reassessment of the value of a large range of assets as costs and opportunities become apparent. The longer meaningful adjustment is delayed, the more transition risks will rise”.
Climate risks display several distinctive features: breadth (in terms business lines, sectors and geographies), magnitude (potentially non-linear and irreversible impacts), foreseeable nature, dependency on short-term actions (actions taken today partially determine size of impacts in the future) and uncertain time horizon (stretching far beyond conventional business planning).
The BoE is now increasingly active in assessments whether “companies can seize the opportunities in a low carbon economy and which are strategically resilient to the physical and transition risks associated with climate change”. Importantly, the BoE now considers that doing so is “consistent with our financial stability and prudential mandates.”
Regarding the insurance sector, he highlighted that “general insurers and reinsurers are on the front line of managing the physical risks from climate change. Insurers have responded by developing their modelling and forecasting capabilities, improving exposure management, and adapting coverage and pricing. In the process, insurers have learned that yesterday’s tail risk is closer to today’s central scenario”.
The banking sector used to consider climate change as beyond the planning horizon. However, this is changing Mark Carney notes: “banks have begun considering the most immediate physical risks to their business models – from the exposure of mortgage books to flood risk, to the impact of extreme weather events on sovereign risk. And they have started to assess exposures to transition risks in
anticipation of climate action. This includes exposures to carbon-intensive sectors, consumer loans secured on diesel vehicles, and buy-to-let lending given new energy efficiency requirements.”
The Prudential Regulation Authority (PRA) is about to publish the final version of “Supervisory Statement for banks, insurers and investment firms” which “will set out the PRA’s expectations regarding firms’ approaches to managing the financial risks from climate change”. Important aspects include governance, risk management, “regular use of scenario analysis to test strategic resilience” and disclosure of climate risks.
He said that the “ PRA has found that despite the sophistication of insurers in modelling climate risks, there are still gaps in their own risk management” (e.g. “cognitive dissonance in some insurers whose careful management of climate risks on the liability side of their balance sheets is not always matched by similar considerations on the asset side”) and “PRA’s banking survey last September found that, although almost three quarters of banks recognised the risks of climate change, only one in ten were taking a long term, strategic approach to them.”
The BoE expects firms to use scenario analysis “as part of their assessments of the impact of climate risks on their balance sheet and broader business strategy”. However, many questions remain about how such scenario analysis should be done. Scenarios ought to be rigorous, comprehensive, with assumptions and methodologies sufficiently transparent for comparison, and questioning.
This is not an easy task: firms can either develop their own transition scenarios or use available models. He pinpointed that “Climate scenarios aren’t forecasts, but data-driven narratives that help companies think through different possible futures”. Existing models are provided by the TCFD report. Furthermore, “PRA’s Climate Financial Risk Forum will work with industry to review tools and metrics, with the view to publishing reference scenarios and standard assumptions: The most widely used and well-known are the IEA transition scenarios, which model six different assumed pathways and associated temperature increases. For modelling physical risks, the IPCC’s four Representative Concentration Pathways (RCPs) fix greenhouse emissions and analyse the resulting change to the climate.”
The assessment of the resilience of financial system to shocks resulting from both physical and transition risks requires the use of stress testing. Stress testing “involves linking high-level data-driven narratives on the evolution of physical and transition risks to quantitative metrics to measure the impact on the financial system.”
The climate change scenario stress tests have a twofold objective: 1) “To consider whether, across the financial system, financing flows are consistent with an orderly transition to the climate outcome set out in the Paris agreement” and 2) “To consider whether the financial system would be resilient to shorter-term shocks – including a climate “Minsky moment” when climate risks materialise suddenly.”
Much work still remains to be done in this area, yet there are signs of encouraging recent progress. The BoE is currently working with other central bankers and supervisors within the Network for Greening the Financial System (NGFS) “to develop a small number of high-level scenarios: The analytical work is split into three work streams and the research will be published in April 2019: WS1 microprudential/supervisory; WS2 macrofinancial; and WS3 Scaling up green finance.”
The final area mapped-out by Mark Carney is the return on low-carbon investment. The transition could require annual $3.5trn investments in energy sector according to the IEA, while overall infrastructure investment compatible with sustainable economy is expected to require around US$90 trillion between 2015 and 2030.
While green bonds are an important and fast-growing catalyst, they alone will not be sufficient to finance the low-carbon transition. “Achieving the transition will require mobilizing mainstream finance.” Mainstreaming of ESG consideration could help in this regard. Better quality and higher availability of sustainability data, enhanced data analytics thanks to improving AI and Machine Learning can all contribute to the development of ESG investment strategies. The underlying assumption is that an ESG rating is a reliable approximation for company’s sustainability performance. Several ESG rating agencies exist, but their methodological divergences and opacity result in limited comparability of their ratings. Moreover, one can question the quality of corporate disclosure and the quality of ESG rating process by agencies themselves. However, an encouraging recent development is the decision of ESMA to accredit Beyond Ratings as a credit rating agency. Beyong Ratings combines ESG evaluation with traditional credit rating and the recent accreditation translates into stricter back-testing requirements and methodological robustness checks, though it is for the moment limited to central, regional, and local governments as well as (both supranational and national) policy-driven financial institutions. Whether similar advancements will be made also for corporate ratings remains to be seen.
The rising interest in sustainable investment is driven by expectations of excess returns through three channels:
1) “Companies that score well on ESG metrics could better anticipate future climate-related risks and opportunities. This makes them more strategically resilient and therefore able to anticipate, and adapt to, the risks and opportunities on the horizon, generating true alpha from ESG.”
2) “Strong ESG scores could signal that a firm is more naturally disposed to longer-term strategic thinking and planning. Climate disclosure is increasingly seen not only as necessary in and of itself, but also as informative about the extent to which companies are focused on long-term value creation.”
3) “Strong ESG firms may enjoy valuation premiums consistent with shifting investor preferences.”
While the academic debate whether ESG can generate alpha is still ongoing, encouraging results start to emerge. According to BlackRock, ““Tilt” strategies, which overweight ESG stocks, and “momentum” strategies, which focus on companies that have improved their ESG rating, have outperformed global benchmarks for close to a decade.” UBS has launched a project giving investors the choice how much weight they place on different ESG factors and BlackRock launched six Exchange Traded Funds (ETFs) combining “ESG uplift and a 30% reduction in carbon emissions”. In a research paper published in 2018, Natixis also identified a “green alpha” in equity markets by showing an outperformance and a better resilience of climate-friendly values. In particular, sectors for which climate issues represent key topics – such as Utilities - show strongest correlation between financial track record and climate performance.
 “A global approach to sustainable Finance”, Brussels, 21 March 2019, Watch the full recording of the conference https://webcast.ec.europa.eu/conference-on-sustainable-finance-21-03-2019
 Full speech available here : https://www.bankofengland.co.uk/speech/2019/mark-carney-speech-at-european-commission-high-level-conference-brussels
 Speech by Mr. Mark Carney, Governor of the Bank of England and Chairman of the Financial Stability Board, at Lloyd’s of London, London, 29 September 2015. Available here : https://www.bis.org/review/r151009a.pdf
 The concept refers to a sudden collapse of asset values and a sharp drop in market liquidity. It was coined in 1998 by Paul McCulley of PIMCO and reached a wider audience during the financial crisis of 2007/8.
 Current supporters of the TCFD include three-quarters of the world’s globally systemic banks, 8 of the top 10 global asset managers, the world’s leading pension funds and insurers, major credit rating agencies and the Big Four accounting firms. In total, these financial firms manage almost US$110 trillion in assets.
 The other channel concerns liability risks. These stem from parties who have suffered loss from the effects of climate change seeking compensation from those they hold responsible