Carbon Risk and Green Finance

Aaron Ezroj

• Publisher: Routledge
• Year: 2020
• Print ISBN: 9780367559915
• eBook ISBN: 9781000320268
• Edition: 1
• Topic: Economics
• Subtopic: Finance
• Index: Economics

As the world plans for economic recovery following the global COVID-19 pandemic, major economies are looking to comprehensive strategies for addressing carbon risks and identifying green finance opportunities. Since Bank of England Governor Mark Carney and Michael Bloomberg began tackling climate change as a financial concern, the international financial community has been developing sophisticated analytical tools that will enable the success of comprehensive efforts to address carbon risks and identify green finance opportunities.

This timely publication offers a cutting-edge analysis of the financial aspects of climate change. It discusses the most important analytical tools, their origin, how they work, where they can go, and how they fit into a larger strategy. First, reporting frameworks can allow companies to see how well they are addressing carbon risks, in particular with respect to the recommendations of the Task Force on Climate-related Financial Disclosures. Second, by quantifying how much greenhouse gas companies emit into the atmosphere as a direct or indirect result of their operations, carbon footprint calculations can help identify carbon risks with particular companies, especially within supply chains. Third, brown taxonomies can help investors identify current carbon risks by classifying fossil fuel assets in a systematic manner. Fourth, green taxonomies can help investors identify current green finance opportunities by classifying sustainable activities in a systematic manner. Fifth, scenario analysis for assets can help investors identify future carbon risks and green finance opportunities. Finally, stress testing for liabilities can help insurers and banks address future carbon risks and better inform policymakers.

Scholars, policymakers, and business professionals will find this book informative. They will gain a comprehensive understanding of the analytical tools supporting efforts to address carbon risks and identify green finance opportunities. This will hopefully make these individuals more successful in their personal endeavors to build a more sustainable and resilient economy for future generations.

1 Climate change becomes a financial concern

On a fall evening in 2015, one of the world’s most esteemed bankers argued for addressing climate change. The head of the Bank of England, Governor Mark Carney, said the following at an exclusive business dinner gathering in London.

There is a growing international consensus that climate change is unequivocal. Many of the changes in our world since the 1950s are without precedent: not merely over decades but over millennia.

(Carney 2015)

In what started out as a speech one would expect from an environmentalist rather than a financial regulator, Governor Carney went on to describe how climate change presents serious financial risks. He explained that some carbon risks were already observable, such as losses from the increasing frequency and severity of weather events. Specifically, in just a few decades, weather-related loss events had increased by several times, and insurance losses had grown exponentially. This has led to insurers exiting certain markets and consumers having difficulty finding coverage (Carney 2015).

Still other carbon risks were lurking which could impact the global economy as a whole, including the possibility of a financial shock from a reevaluation of fossil fuel investments. According to Governor Carney, global monetary markets did not appear to be properly valuing and assessing the risks behind fossil fuel investments. Fossil fuel companies and those connected with them were being valued as if all available reserves could be exploited. However, if the world wanted to avoid catastrophic climate change, it was estimated that the majority of reserves could not be burned. If there was a sudden market correction acknowledging this, there could be a market shock, which some have referred to as the bursting of “carbon bubble.” To avoid a tragic outcome, Governor Carney stated that the world’s financial leaders needed to work together to ensure a smooth transition to a low-carbon economy (Carney 2015).

Later that year, with growing global concerns over the potential dire consequences of climate change, delegates from nearly two hundred countries met at an annual United Nations Climate Change Conference in Paris. At that meeting, delegates negotiated what is now referred to as the “Paris Agreement,” where they committed to limit average global temperatures to no more than a 2 degrees Celsius increase above preindustrial levels and further sought a well below 2 degrees Celsius goal with a 1.5 degrees Celsius target (Paris Agreement 2015, Art. 2). Around this time, the United Nations also unveiled seventeen Sustainable Development Goals, with one of the major ones being climate action (UN 2015).

Following the Paris Agreement, which has been referred to as a tipping point in combating climate change (CDP n.d.), governments mobilized, including financial supervisors who make financial rules and regulators who enforce actions under these rules, starting to outline strategies for a smooth transition to a low-carbon economy. Governor Carney’s Bank of England, the Bank of France, and the Dutch Bank all moved to formally recognize climate-related financial risks. Notable among the efforts of these pioneering financial regulators, the French government implemented the groundbreaking French Energy Transition Law. This law strengthened carbon disclosure requirements for companies operating in France and introduced them for institutional investors. In particular, the law required companies to disclose climate-related financial risks in annual reports, along with measures to reduce these risks. Moreover, the law required institutional investors to disclose in their annual reports how environmental considerations are taken into account when investing and how their policies are aligned with national transition strategies (French Energy Transition Law 2015, Art. 173).

The Chinese government pushed a powerful green agenda. This included developing the first government guidance for green loans and green bonds. Together these efforts quickly helped direct billions of dollars into sustainable green growth, transforming China into an international leader in green development (CBIRC 2012; PBOC 2015; NGFS 2019, 34).

California government entities identified thermal coal as an asset that could potentially become stranded and pushed for divestment (Jones 2016). The states’ two largest pension funds divested from thermal coal. Then the state’s insurance regulator asked insurers to voluntarily divest from thermal coal and started tracking thermal coal in insurers’ investment portfolios.

With government agencies around the world starting to focus on a smooth transition to a low-carbon economy, collaborations among countries also started to emerge. With the insurance industry suffering some of the first climate-related financial losses, a global partnership emerged between insurance supervisors and regulators. Working with the United Nations, the United Kingdom, France, the Netherlands, and California partnered with other governments to launch the Sustainable Insurance Forum. Representing the first collection of financial supervisors and regulators of its kind, this group started convening meetings to discuss the sustainability challenges facing insurance supervisors and regulators and decided on best practices to address these challenges (SIF n.d.).

Meanwhile, the business community also took action. Companies expanded their participation in climate change efforts by becoming signatories of climate change initiatives, calculating and reporting greenhouse gas emissions, responding to surveys on carbon risks, divesting from or engaging regarding assets that could potentially become stranded, increasing their investments in green bonds, and working collaboratively with climate modelers. Previously niche efforts, these activities started becoming mainstream business activities.

Then, with both governments and businesses moving to recognize the need to ensure a smooth transition to a low-carbon economy, something pivotal happened. The two groups came together to develop overarching financial disclosure recommendations that could better inform the understanding of material risks. At the behest of Governor Carney and Michael Bloomberg, the G20 Financial Stability Board established the Task Force on Climate-related Financial Disclosures (TCFD), which included financial experts from Europe and the United States as well as other parts of the world (TCFD 2017a, 3).

The TCFD opened up a dialogue. Governments and companies that had already been active in this space commented on the TCFD recommendations as they were being prepared. Of note, the collection of insurance supervisors and regulators making up the Sustainable Insurance Forum filed comments jointly as financial supervisors and regulators. In comments titled “Leading Insurance Supervisors Support Adoption of Climate Disclosure Recommendations,” the organization’s supervisors and regulators explained the unique role that insurers play with disclosure and echoed the importance of the recommendations providing a comprehensive new standard for disclosing climate-related financial risks and opportunities (SIF 2017a).

In the middle of 2017, the TCFD released its final report. Now-TCFD Chair Bloomberg opened the report with a letter to Governor Carney stating that the recommendations will lead to “smarter, more efficient allocation of capital, and help smooth the transition to a more sustainable, low-carbon economy” (Bloomberg 2017, i). As explained in this letter, the recommendations will specifically help companies routinely consider the effects of climate change in business and investment decisions and disclose climate-related financial information. The letter closes with the statement:

The risk climate change poses to businesses and financial markets is real and already present. It is more important than ever that businesses lead in understanding and responding to these risks – and seizing the opportunities – to build a stronger, more resilient, and sustainable global economy.

(Bloomberg 2017, i)

The final report and supplemental documents themselves identify core elements along these lines, including governance, strategy, risk management, and metrics and targets. To begin with, on governance, the final report seeks the adoption of corporate governance strategies that account for carbon risks. In particular, the final report notes that it is especially important that the individuals making board and investment decisions be knowledgeable on climate risks and opportunities. Next, for strategy, the final report seeks transparency on the material financial risks and opportunities that have been identified over the short, medium, and long term. Further, with respect to risk management, the final report seeks information on the manner in which climate-related risks are managed and otherwise evaluated (TCFD 2017a, 13–23). Finally, with metrics and targets, the final report and supplemental documents detail different types of analytical tools that can inform corporate governance and facilitate disclosure. Principal among these tools is discussion of scenario analysis. This tool allows for projecting the impacts of climate change based on the modeling of certain possible scenarios. According to the report, a key means for using this tool is to determine alignment with the objectives of the Paris Agreement. On the one hand, such a tool can evaluate the impact on financial markets as economies move toward Celsius targets of 2 degrees or below. On the other hand, such a tool can also be used to evaluate the impact of an increased frequency and severity of climate-related weather disasters if economies fail to meet these targets (TCFD 2017a, 25–30, 2017b). Figure 1.1 explains the core elements of the TCFD recommendations.

Following publication of the TCFD final report, governments and businesses began centering their messaging around the TCFD recommendations. The collection of international insurance supervisors and regulators making up the Sustainable Insurance Forum released a Sustainable Insurance Forum statement in support of the TCFD recommendations, saying that they welcomed the recommendations and looked forward to working to make them a reality (SIF 2017b). Further, the supervisors and regulators specifically identified aspects of corporate governance, such as the application of the scenario analysis tool, as main components of their intended efforts to support the TCFD recommendations (SIF n.d.). The Sustainable Insurance Forum also later published a joint report with the international insurance standards setting organization, the International Association of Insurance Supervisors, on how the insurance sector has been incorporating the TCFD recommendations (IAIS and SIF 2018).

Figure 1.1Core Elements of Recommended Climate-related Financial Disclosures

Source: Task Force on Climate-related Financial Disclosures

French President Emmanuel Macron convened a One Planet Summit with global climate leaders. Here international banking supervisors and regulators established the Central Banks and Supervisors Network for Greening the Financial System (NGFS 2017). The NGFS’s stated purpose has been to strengthen the global response that is necessary to meet the Paris Agreement objectives and to increase the financial system’s role in managing risks and mobilizing capital for green and low-carbon investments. The group has set up three dedicated workstreams: supervision, macrofinancial, and mainstreaming green finance, which involves mobilizing capital for environmentally sustainable activities. The NGFS later published a report encouraging corporate disclosure in line with the TCFD recommendations (NGFS 2019).

Around the same time, California issued its Trial by Fire report highlighting the impact that climate change is having on wildfires and the risk that climate change presents to over five trillion in actively managed assets held by insurance companies operating in California (Mills et al. 2018). In the foreword, then-California Insurance Commissioner Dave Jones explained:

Disclosure of climate-related risks to the financial sector is important for the sustainability of the global and United States financial systems generally, and the insurance sector in particular. In 2017, the G-20 Financial Stability Board’s Task Force on Climate-related Financial Disclosures issued its recommendations for climate risk disclosures for each economic sector, including the insurance sector. Insurers, investors, policyholders, and regulators should all support and implement these recommendations.

(Jones 2018, ii)

The California Department of Insurance and the Swiss Ministry of Environment also published initial widescale applications of scenario analysis on assets in investment portfolios. Findings were featured in an article in The Economist with a self-explanatory title: “Markets may be underpricing climate-related risk” (Piotrowski 2018).

A growing number of companies also publicly endorsed the TCFD recommendations by signing up as supporters and publishing reports that either directly or indirectly referenced the recommendations. For instance, companies released reports explaining how they addressed climate change and labeled them TCFD reports or TCFD and French Energy Transition Law reports when doing business in France. Companies examined greenhouse gas emissions throu...

Table of contents

• Cover
• Half Title
• Series
• Title
• Copyright
• Dedication
• Contents
• List of figures
• List of tables
• Preface
• Acknowledgments
• 1 Climate change becomes a financial concern
• 2 Reporting frameworks
• 3 Carbon footprint calculations
• 4 Brown taxonomies
• 5 Green taxonomies
• 6 Scenario analysis
• 7 Stress testing
• 8 A comprehensive strategy requires analytical tools
• Appendix A – Glossary of terms
• Appendix B – Timeline
• Index