Finance need an overhaul to price in climate change risk and push green agenda forward
Why did the credit and wider financial system only take off in the last 400 years? Despite money and lending being around for millennia, financial services only truly got going alongside the Enlightenment.
According to the writer Yuval Noah Harari, the fundamental shift was to be found in humanity’s belief about the future. In previous eras, humans looked to the good old days for inspiration, to Rome, to Greece, to the mythical beginnings of man. There was a general belief that humanity had erred and long-term decline was inevitable. So why invest in the future if it is going to be worse than the present? Philosophically, there was no value in risk.
That all changed with the dawn of the scientific revolution. Science showed that new ideas and technologies could create a better future, so it was worth risking today’s capital for something better tomorrow.
The future was also more predictable through better ways to calculate and price risk. Thus credit and insurance flourished to serve a more optimistic world. Scientists, inventors and explorers with an inspiring vision of the future looked to finance to help turn those visions into reality. Whereas Columbus had to beg royalty to fund his voyages, banks and insurers made distant seafaring a possibility for thousands more.
This enabling role still sits at the heart of finance today. It exists to facilitate society in solving its problems and achieving a better world. Without the investment of shareholders in AstraZeneca, or insurers, or banks, the UK’s world-leading vaccine programme might still be stuck in a university lab.
Since this is the central role of the financial system – enabling a brighter future by letting people take risks and invent new solutions – then there can be few better challenges for it than climate change. Around the world, societies have woken up to the need for a more sustainable economy and the financial system must help them to achieve that.
In a new report from the think tank Policy Exchange, the authors argue for the UK to lead reforms that would align the financial system with that sustainability agenda. With our presidencies of the G7 and the UN climate conference COP26, we’re in a position to do so.
As Mark Carney put it, “changes in climate policies, new technologies and growing physical risks will prompt reassessments of the values of virtually every financial asset.”
From mortgages attached to housing on flood plains, to commodities exposed to ecological volatility, to pensions invested in fossil fuel companies, environment-related risks stretch into almost every aspect of the system. Yet markets are not accurately pricing in this endemic risk.
The inability to assess risks properly makes the market less able to distinguish between assets that are low-risk and can help solve the problem, and those that are making it worse. This is not necessarily the fault of financial firms. In many cases, it is down to public and central bank policies.
Take, for example, quantitative easing. The QE programmes of most central banks do not include assessments of environment-related risks when buying corporate assets. This entrenches existing fossil-fuelled systems and further dampens risk signals in the market.
As Policy Exchange points out, there are other such failures in finance. Climate change barely features in bank capital adequacy requirements, whereas other emerging risks like cybersecurity increasingly do. There is also a lack of standardisation in risk reporting, so that firms find it harder to acquire good information about environment-related risks. Furthermore, risk is only part of the story – to effect real change, investors, lenders and insurers must deliver transition plans that move the system to a sustainable footing.
The UK has already led the way on many of these issues. Canada is the world leader in sustainable finance and just last week the Government announced £10million to fund a Centre for Greening Finance & Investment.
This shows global leadership, but now we must bring others with us. As hosts of the G7 and COP26, we have the opportunity to do that. Just as it has helped create a brighter future for millions, the City and its global network must lead the way to a brighter and greener future for the world.