1Climate risks & financial regulation
1.The UK has commitments under the Climate Change Act 2008, the UN’s Sustainable Development Goals (SDGs)—goal 13 ‘climate action’, and goals 8, 9 and 11 which contain commitments to sustainable and resilient economic growth—and the 2015 Paris Agreement on climate change to keep global temperatures rises to well below two degrees Celsius. We launched our green finance inquiry in November 2017 to examine how the UK could both mobilise the investment necessary to meet the challenge of climate change and encourage greater consideration of environmental risks in financial decision-making. We held a roundtable event and conducted five days of hearings with investors, asset owners, experts, financial regulators and Government ministers. We would like to thank all of those who contributed, especially our Specialist Adviser recruited for this inquiry, Mike Clark, a Fellow of the Institute and Faculty of Actuaries who has a track record of work on sustainable finance.1
Climate change risks: physical, liability and transition
2.Our first report on green finance, published on 16 May 2018, looked at how to secure investment in clean energy specifically.2 In this report we focus on how to ensure environmental risks like climate change are factored into financial decision making across the economy. The Bank of England and others have identified three types of risks as arising from climate change: physical, liability and transition.3
3.The physical impacts of climate change, such as a rise in sea levels and increase in the frequency and intensity of extreme weather events, will pose increasing economic risks for a range of businesses and investments—from food and farming to infrastructure, home building and insurance. In the UK alone, climate change is projected to: increase the risk that business assets and operations are damaged and disrupted by flooding; degrade some of our most productive agricultural land; reduce water supplies; increase the frequency and intensity of heatwaves; and stress transportation, energy and water infrastructure.4
4.Liability risks may result from climate change when those who suffer losses as a result of climate change take legal action to recover damages from those that can be found responsible. For example, five fossil fuel firms—BP, ExxonMobil, Chevron, ConocoPhillips and Shell—are facing legal action from the City of New York, which is seeking to recover the costs of protecting the city from flooding and erosion due to climate change.5
5.Transition risks could also face companies in high-carbon sectors who fail to diversify and adapt to policies introduced in response to what the science tells us is necessary to avoid catastrophic climate change. In December 2015, 195 countries signed the Paris Climate Agreement to limit global temperature rises to well below 2°C by 2100, marking the beginning of a global process of regulatory action to curtail climate-changing emissions from fossil fuels and deforestation. Firms that do not make a timely transition and remain overly invested in climate-changing activities could face costly regulatory action, suffer reputational damage or see their assets become stranded as carbon prices rise.6 A Bank of England paper published in 2016 warned that ‘a sudden, unexpected tightening of carbon emission policies could lead to a disorderly re-pricing of carbon-intensive assets’.7 Such a scenario could arise if the effects of climate change accelerated due to positive feedback mechanisms, for example.
6.The risks identified by the Committee on Climate Change and the Bank of England mean that climate change is increasingly regarded as a material risk to a wide range of investments and economic activities,8 particularly to long-term investments like pensions. As the chair of HSBC’s pension scheme, Russell Picot, pointed out:
‘ … if you are a member of a defined contribution pension scheme—that is most young people nowadays—the reality is that you are probably going to be 40 to 50 years away from retirement, and whatever those sorts of timescales climate risk and ESG factors will be material to the financial performance of your funds. I think that is almost a statement of the obvious.’
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Environmental, social and governance (ESG) refers to the three central factors in measuring the sustainability and ethical impact of an investment in a company or business. |
7.In 2015, consultants Mercer published Investing in a Time of Climate Change, a report outlining four plausible climate change scenarios (considering temperature rises by the end of the century from 2°C to 4°C) and the impact that each scenario could have on investment returns. The report suggested that, under all the scenarios it modelled, climate change—or society’s response to it—would have an impact on investment returns.9
The scale of the risks
8.Steve Waygood from the insurance company Aviva provided a sobering assessment of the scale of the risks that climate change could pose to financial stability over the course of the twenty first century if the Paris Agreement’s aspiration to limit global temperature rises to 1.5–2 degrees is not achieved:
‘Many scientists are saying that 4, 5, 6 degrees is at least a risk that we need to be considering. At 4 degrees the insurance business model fails to exist. We could not underwrite to the price that the economy can afford. At 6 degrees […] the present value of risk from 6 degrees change is £42 trillion. Of course, these are models but, in terms of the hazards that we would experience, we are talking about economic meltdown.’10
The Bank of England
9.In 2014, our predecessor Committee called on the Bank of England (BoE) to monitor the risk that climate change could pose to financial stability.11 The Bank Governor Mark Carney told our predecessor committee in October 2014 that ‘the Financial Policy Committee (FPC) would consider the [climate risks] issue as part of its regular horizon-scanning work on financial stability risks’.12 The Bank of England and Governor Mark Carney, as Chair of the Financial Stability Board, have gone on to help put climate risk on the agenda of the G20 and were instrumental in the international Financial Stability Board establishing the Task Force on Climate-related Financial Disclosures (whose recommendations we will turn to in Chapter Three). The Bank of England has said:
‘Central banks and financial regulators have a core responsibility to understand risks to financial stability and the financial institutions which they supervise. There is growing recognition and evidence of the financial risks from climate change and their relevance to central bank mandates.’13
A Tragedy of the Horizon?
10.In his September 2015 speech on ‘the Tragedy of the Horizon’ the Bank of England Governor, Mark Carney, described how the timescales involved in climate change mean that businesses, politicians, and regulators may be late to recognise and respond to the risks:
‘A classic problem in environmental economics is the tragedy of the commons. The solution to it lies in property rights and supply management. Climate change is the Tragedy of the Horizon.
We don’t need an army of actuaries to tell us that the catastrophic impacts of climate change will be felt beyond the traditional horizons of most actors—imposing a cost on future generations that the current generation has no direct incentive to fix. That means beyond: the business cycle; the political cycle; and the horizon of technocratic authorities, like central banks, who are bound by their mandates.
The horizon for monetary policy extends out to 2–3 years. For financial stability it is a bit longer, but typically only to the outer boundaries of the credit cycle—about a decade. In other words, once climate change becomes a defining issue for financial stability, it may already be too late.’14
11.The Treasury and Department for Business Energy and Industrial Strategy’s (BEIS) submission to our inquiry, however, argued that the market is already in the process of integrating climate risks and opportunities.15 It cites studies showing that companies with higher ESG scores tend to have higher operational metrics such as Return On Equity, Return On Capital Employed and lower net debt/Earnings Before Interest, Tax, Depreciation and Amortisation.16 This leads to premium valuations and lower share price volatility. The Government says that ‘all of this points to an ongoing, market-led approach to promoting long-term sustainable development and investment.’17
Misaligned incentives
12.Despite the Government’s assurances, we heard again and again during our inquiry how a structural focus on short term returns in the UK financial system often leads to the neglect of longer-term considerations—including environmental sustainability and climate change-related risks and opportunities. We were told that there are misaligned incentives at each stage of the investment chain that mean capital markets do not adequately price sustainability. For example, we heard that:
- The ‘fiduciary duty’ of pension scheme trustees is misinterpreted as a duty to maximise short-term returns.18
- The quarterly earnings cycle and structure of remuneration for investment consultants and fund managers encourages a pursuit of short-term returns rather than long-term value creation.19
- There can be a tendency to underinvest in physical assets, technology innovation, and employees’ skills in preference for nearer term gains from financial mergers, acquisitions or restructuring.20
- Investment banks are incentivised to increase short term market activity. Sell-side analysts rarely produce long-term sustainability-oriented research due to commercial conflicts of interest and pressure from company management/investor relations.21
- Credit ratings agencies do not sufficiently incorporate long term considerations into their credit analysis, despite sustainability risks often being of material importance to a company’s performance and credit worthiness.22
- Stock exchanges are themselves listed companies and are thus incentivised to increase trading volumes to improve their own share price. As a consequence, holding periods are getting shorter and listed companies are pressured to focus on short term returns.23
We focused our attention on two ways of factoring environmental risks like climate change into financial decisions:
- Clarification of pension trustees’ fiduciary duty and updated guidance and rules on the governance of pension funds;
- Company reporting and implementation of recommendations on climate-related financial disclosures.
We will explore these issues in greater detail in Chapters Two and Three respectively.
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The Investment Chain
This info-graphic, provided by Aviva, illustrates how money is transferred along the investment chain. Individual pension savers and investors on the right may invest collectively as institutional investors—through pension schemes or insurance companies—or as individual investors through retail financial advisors. Institutional asset owners often take the advice of investment consultants who, in turn, recommend which asset manager to choose. Such fund managers decide which company stocks to buy or sell on stock exchanges from brokers who are typically part of an investment bank providing investment analysis. Meanwhile, the companies on the left invest this capital to generate a return for their shareholders. |
13.There is growing recognition that climate change—and the world’s response to it—will pose financial risks over the coming years and decades. In the 40 to 50 years it will take today’s young people to reach retirement age the projected rise in sea levels and the increased frequency and intensity of extreme weather events will have economic consequences for a range of investments—from food and farming to infrastructure, home building and insurance. Proper recognition and disclosure of these risks and opportunities would help financial markets to work more efficiently and will enable UK institutions and investors to position themselves to benefit from the low-carbon transition.
14.The Bank of England and Governor Mark Carney have shown leadership on this issue, setting out the risks to financial stability and putting the issue on the agenda of the G20. The Government must do more to prevent the ‘tragedy of the horizon’ by ensuring that financial institutions, businesses and regulators factor long term environmental risks like climate change into financial decision making.
1 Michael John Clark: Declaration of Interests: Ario Advisory, Founder Director and Owner; Brunel Pension Partnership Ltd (“Brunel”), Non-Executive Director; Institute and Faculty of Actuaries, Fellow; Rype Office Limited, Shareholder, Provider of sustainable office furniture; WHEB Asset Management, Member of independent Investment Advisory Committee
2 Environmental Audit Committee, Green Finance: mobilising investment in clean energy and sustainable development (May 2018)
3 Bank of England Prudential Regulation Authority, The impact of climate change on the UK insurance sector (September 2015)
4 Committee on Climate Change, UK Climate Change Risk Assessment 2017 (July 2016)
6 Q294 and https://www.forbes.com/sites/mikescott/2018/03/08/1-6-trillion-of-investments-at-risk-if-fossil-fuel-firms-fail-to-heed-climate-targets/#12f344aa2a03
7 Bank of England, Staff Working Paper No. 603: Let’s talk about the weather: the impact of climate change on central banks (May 2016)
8 The Task Force on Climate-related Financial Disclosures, Final Report (June 2017)
9 Mercer, Investing in a Time of Climate Change (2015)
10 Q53
11 Environmental Audit Committee, Green Finance (March 2014)
12 https://www.parliament.uk/documents/commons-committees/environmental-audit/Letter-from-Mark-Carney-on-Stranded-Assets.pdf
13 https://www.bankofengland.co.uk/-/media/boe/files/quarterly-bulletin/2017/the-banks-response-to-climate-change.pdf
14 https://www.bankofengland.co.uk/-/media/boe/files/speech/2015/breaking-the-tragedy-of-the-horizon-climate-change-and-financial-stability.pdf
15 HM Treasury and Department for Business Energy and Industrial Strategy (GFI0027)
16 HM Treasury and Department for Business Energy and Industrial Strategy (GFI0027)
17 HM Treasury and Department for Business Energy and Industrial Strategy (GFI0027)
18 Aldersgate Group (GFI0003), Aviva (GFI0024), UKSIF (GFI0002)
19 Aldersgate Group (GFI0003), Aviva (GFI0024), ClientEarth (GFI0012), ShareAction (GFI0013)
20 Principle for Responsible Investment (GFI0029)
21 Aviva (GFI0024)
22 Aviva (GFI0024), WWF (GFI0022)
23 Aviva (GFI0024)
Published: 6 June 2018