April was a big month for international cooperation in the financial sector to tackle climate change. Two new supranational groups made major strides: The Central Banks and Supervisors Network for Greening the Financial System (NGFS) published its first comprehensive report on addressing climate risk through financial oversight, and the Coalition of Finance Ministers for Climate Action was formed to enable finance ministers to ramp up ambition on the Paris Agreement objectives.
Framing these events, Governor of the Bank of England Mark Carney, Head of the Banque de France François Villeroy de Galhau, and NGFS Chair Frank Elderson penned an open letter on the financial risks of climate change. In outlining the key findings and messages of the NGFS report, they noted that “climate change is a global problem, which requires global solutions, in which the whole financial sector has a crucial role to play.”
These events followed closely on the heels of Mr. Carney’s speech on the New Horizon at the end of March 2019. Mr. Carney – the previous Chairman of the Financial Stability Board (which heads the Task Force on Climate-related Financial Disclosures, or TCFD) – spoke about the prerequisites necessary for the transition to a low-carbon, climate-resilient financial system. His recent speech was, in many ways, an update to his famed 2015 speech on the Tragedy of the Horizon, which pointed out that the timeframes required to observe the impacts of climate change lie beyond the planning timeframes for businesses, governments, and regulatory bodies; that is, society is too myopic to see past a short-term time horizon, and thus prepare for, the impacts of climate change.
This kind of myopia is not a new phenomenon. Also known as ‘short-termism’, it is defined by the CFA Institute as “excessive focus on short-term results at the expense of long-term interests,” and some studies have shown that it was a significant factor in the 2007-2009 financial crisis. While the business community has long identified problems with short-termism, it has been difficult to make headway with the current financial system’s structure of quarterly earnings targets and preoccupation with current share prices. A similar here-and-now calculus has led to underinvestment in infrastructure and failure to plan for the long term. For example, while a one-in-a-hundred-year flood only has a tiny probability of occurring each year, these odds grow rapidly over a multi-decade time frame, and climb higher still when considering that the rate of warming is accelerating. Yet many companies and investors still fail to account for even the one-in-a-hundred flood risk, let along changing flood risk profiles in their investments. Factors such as use of high discount rates, short asset ownership life-cycles, and incentives for prioritizing near-term risks and opportunities often lead to neglect of investment considerations ten years or more in the future.
However, in recent years, numerous articles have been published documenting the pushback against such myopia, and a growing number of CEOs are prioritizing the long-term health of their companies over short-term profits. These actions have been spurred in no small measure by environmental, social, and governance (ESG) considerations of shareholders who value non-financial performance and long-term value creation.
Other challenges are also inhibiting the integration of climate risk considerations by financial decision-makers. In the first instance, many lack the sophisticated skills and tools to translate complex scientific data into financial terms which are meaningful for their unique decision making needs. Further, though the information and tools to discern climate risks in financial terms are increasingly available, climate-related and environmental accounting standards proliferate, from the Sustainability Accounting Standards Board (SASB) and the TCFD to the Global Reporting Initiative (GRI) and beyond. Even for the relatively better-established disclosure and reporting standards, different stakeholders can have wildly different definitions and interpretations of the various ESG factors. The absence of consensus and harmonization around the definitions of ‘green’ and ‘sustainability’, and what constitutes as a climate-friendly investment, thus also hampers would-be investors in climate solutions. The heterogeneity also makes it difficult for the financial market to assess and differentiate sustainable and non-sustainable assets.
The NGFS and the new Coalition of Finance Ministers are dedicated to helping the financial system address these issues, among the most important structural barriers constraining the financial sector’s response to climate change. The NGFS, launched in 2017, boasts a membership of 34 central banks from around the world. It aims to share best practices, assist in the development and integration of climate-related risk management practices (especially in the financial sector), and to help mobilize finance to support the transition to a green economy. In its report released earlier this month, the NGFS acknowledges “future [climate] impacts will be determined by actions taken today, which thus need to follow a credible and forward-looking policy path.” Recommendations by the NGFS include climate risk integration into financial stability monitoring and portfolio management, and support for the development of climate-related disclosures and a ‘green taxonomy’ of economic activities, all of which address the issues with short-termism, insufficient data and skills for considering climate change in investment decisions, and muddled terminology and methodologies.
The formation of the Coalition of Finance Ministers for Climate Action, a group of finance ministers from over 20 countries, endorsed a set of six principles (“the Helsinki Principles”) that “promote national climate action, especially through fiscal policy and the use of public finance”, and – similar to the NGFS – are working together to coordinate collective action against climate change through sharing of best practices, macroeconomic policy, and public investment management to mobilize private capital.
Mainstream investors are rapidly taking stock of the materiality of climate risk, and the fiduciary responsibility to manage it; evolving market conditions, investor preferences, and regulatory environments are reflecting climate change considerations as never before. These initiatives (along with other initiatives we will discuss in future posts) are steps in the right direction towards a sustainable, low-carbon and climate-resilient financial system.
