How regulatory bodies respond to climate exposure is critical to a successful green transition
Following a recent wave of announcements from financial regulatory bodies revealing the extent of the global finance sector’s climate risk exposure, Principal Economist for Sustainable Investment János Hidi explores the important role of regulators in incentivising the green transition in the short term for long term macroprudential stability.
Over the past six months, the global finance sector has seen the results of the global stocktake, outcomes from the European Central Bank study on macroprudential frameworks for managing climate risk and findings from the World Economic Forum annual Global Risks Report 2024. All pointed to the overwhelming evidence that the banking sector’s climate risk exposure is too high and that not enough is being done to reduce it, despite the forecast that climate risks are the biggest challenge for the financial sector over a ten-year horizon.
For the global economy to successfully achieve net zero targets, a lot more needs to be done in the short term to ensure climate risk exposure is identified and managed, and sufficient capital investment is secured to aid a successful green transition.
Regulation to improve market transparency on risk exposure
There are increasing regulatory requirements for banks and companies to be more transparent on their current climate risk exposure and carbon footprint. Greater transparency helps identify risk hotspots and support markets in correctly pricing in the associated risks. Risks can be better managed and sudden repricing avoided, just as the 2008 crisis was triggered by securitised mortgages with opaque, misclassified risks.
Evidence shows that a breakdown in the financial intermediation system could trigger a financial crisis that would affect the whole economy and our daily lives. Much of the resources that are urgently needed for an efficient economic and technological transition to a carbon neutral world would be wiped out, exacerbating the challenge of combating climate change. Misguided financial and regulatory decisions in the short term could cause significant challenges met with long-term physical risks of climate change across the world.
The recent crisis in the Florida housing insurance market is a reminder of the risks caused by climate-related events and what happens when risk hotspots are not identified and mitigated.
Hurricanes and wildfires, particularly in Florida and California, have caused insurance premiums to soar and some insurers to go bankrupt or withdraw from the market. This trend is particularly pronounced in hurricane prone areas where the cost of home insurance has increased by a factor of 3 to 4, which many are unable or unwilling to pay. In such cases, either the taxpayers take on the climate risk through the state insurance, or the proportion of uninsured homes increases, further increasing the overall social cost of disasters.
Regulation to incentivise capital investments in low-carbon technology
It is encouraging to see the current efforts by regulatory bodies across the global finance sector to incentivise sufficient capital investment and debt financing in order to reduce emissions in a free market context.
The proactive stance taken by the ECB and other regulators in looking closely at the problem is reassuring, especially given the accelerating pace of change; preparing in advance is essential.
The challenge of market pricing and forecasting the green transition
While global oil and gas production continues to increase, the rapid development of substitute technologies that replace them offers some hope that a climate catastrophe can be avoided. However, the transition comes with its own set of challenges. The rapid uptake of electric cars or solar panels could damage the value of some fossil fuel assets, which could mean a global loss of $1,400 billion that could affect us all through the financial intermediation system.
This accelerating technological shift, and the devaluation and appreciation that will accompany it would need to be anticipated and priced well by markets which is no easy task. Our current financial institutions with their short-term approach may not be well equipped to manage these risks.
The rapidity of change in the energy sector is a key example of this, which has undergone a transformation over the last decade.
Solar power for instance has moved from being reported as the most expensive low-carbon alternative by The Economist in 2014 to the cheapest power generation technology in history in 2020 according to the International Energy Agency. Our more recent analysis in 2023 exploring the role of energy prices in consumer price inflation across different economies revealed that with renewable energy now emerging as cheaper than fossil fuel based energy production, there is potential for faster energy transition measures to ease inflationary pressures and risks.
Further uncertainties in 2024 with short term policy agendas
Market pricing and forecasting is made particularly difficult by the high degree of uncertainty caused by the rapid pace of change. This accompanied by an unpredictable political landscape, further complicates investment allocation decisions. Considering the possibility of elections in more than 50 countries around the world this year, and depending on who comes to power, global decarbonisation efforts could be strengthened or weakened. China seems to have already recognised the need for large investments in low-carbon solutions and regulatory push and have taken proactive action, prioritising the installation of solar panels at a scale bigger than the rest of the world combined. Of course, the Chinese managed economy is not a role model for open market economies, but in democratic countries, regulatory incentives need to be found to ensure that sufficient capital investment and debt financing is provided to reduce emissions in a free market context.
It’s imperative that ample funding is available
Looking ahead, it’s imperative to ensure that ample funding is available to facilitate the transition to a more sustainable future. It would be a shame to complain years later that we are suffering from the effects of climate change because there was not enough money available to finance the transition, or because the banks in Europe and around the world under-priced climate risks in their valuation models.
The current efforts of regulatory bodies such as the ECB is therefore encouraging, and essential, if we are to truly meet net zero goals.