The COVID pandemic has given the world’s financial services markets a clear example they cannot afford to ignore the power of nature and the risk it poses, the Bank of England’s Executive Director, Markets has warned.
Andrew Hauser added that the world was waking up to the demand and need for ESG to be at the heart of the pricing and assessment of climate investments and risk.
Speaking to the Investment Association Mr Hauser said the time for talk was now over.
“2020 is not the likeliest of years for the green revolution to have started paying off in financial markets,” he explained. “With a global pandemic raging, and economic uncertainty at historic highs, issuers, investors and intermediaries might have been forgiven for having their minds elsewhere. But, in fact, after many years of rhetoric from market practitioners, the temperature has changed noticeably.
“Hot air is turning into cold hard fact: – Climate oriented equity indices have outperformed the broader market by 2-5% in 2020, as economic activity has shifted away from travel and other fossil fuel-intensive sectors, and towards online commerce and technology.”
“Green bonds also outperformed their conventional counterparts over that same period and made up a fifth of total European investment grade issuance in September alone,” explained Mr Hauser. “And companies such as VW and Daimler secured material reductions in financing costs (or ‘greeniums’) when issuing their first green bonds, linked to the development of low-emission technologies.
“Governments have been increasingly persuaded of the powerful direct and indirect effects of issuing their own ‘sovereign green bonds’ too, with a raft of countries coming to market for the first time this year: Germany’s innovative dual-bond issuance was five times oversubscribed and commanded a clear greenium; and the European Commission announced that it will fund 30% of its €750bn ‘Next Generation’ budget in the same way.
“More and more investment money is massing on the sidelines. Funds with above-average sustainability ratings have seen big inflows this year, and now hold $4.6 trillion in assets globally. In response, fund managers are overhauling their investment strategies to put sustainability centre stage. “
More than 500 global investors, accounting for over $47 trillion of assets, have committed to support the Climate Action 100+ initiative, aimed at ensuring the world’s largest corporate greenhouse gas emitters take action on climate change.
“For the many organisations, including the Bank of England, that have pushed so hard for climate economics to be taken seriously, these are welcome developments, especially in the runup to next year’s UN Climate Change Conference, ‘COP26’. But, on a moment’s reflection, the fact that this is happening now is less surprising,” he added. “Covid-19 reminds us all that we cannot ignore the daunting forces of the natural world. And it is accelerating economic trends that had previously been slow to reveal themselves. Those trends bring many challenges – but they also bring opportunity, amongst them the chance to advance the pace of climate transition.”
Mr Hauser warned that the time for action could not wait.
“The need to do so is pressing. The UN Environment Programme estimates that global greenhouse gas emissions must be cut by 7.6% in each and every year from now until 2030 to meet a 1.5°C temperature goal. To put that number in context, it’s roughly the decrease the International Energy Agency expects to see this year as a result of Covid-19.”
Well-functioning capital markets are amongst the most powerful tools we have for turning the vision of a resilient carbon neutral economy into reality, Mr Hauser added. “Cold hard price incentives” that reward investments aligned with that goal, and penalise those which aren’t, are worth a thousand entreaties on the dangers of inaction.
“Given the sheer scale of the climate challenge, it is at first glance surprising that financial markets have struggled to reflect it in asset pricing,” he continued.
There were reasons said Mr Hauser: “First, it is in the nature of climate change that many of the costs of failing to address it, and the opportunities for positive change, fall to society as a whole, rather than specific individuals or companies.
“The freedom to emit unlimited amounts of carbon is one example. Markets are notoriously poor at pricing such ‘externalities’. Not all climate risks are externalities, of course. Investor activism can bring consequences to bear on firms viewed to be responsible for climate harm.
“Climate-related natural disasters – already three times more frequent than 40 years ago – fall on real individuals and real companies. Financial markets and institutions can help provide insurance against those risks, but great care is needed to ensure such cover is provided appropriately: too little, and households, companies and lenders will go under-covered; too much, and insurers may be unable to follow through on their commitments,” warned Mr Hauser. “But the most important force for internalising these externalities will be public policy – on climate regulation, carbon pricing and taxing, and legal liability.
“Such policy ‘privatises’ the social cost on specific companies and sectors of the economy and creates powerful opportunities for those first to innovate climate-positive technologies.
“The second factor impeding financial market pricing of climate risk has been the long horizon over which that risk has historically been thought likely to crystallise. Financial markets do not have a great track record pricing such longer-term phenomena, particularly when their scale and incidence is also uncertain – a failing that Mark Carney has called the ‘tragedy of the horizon’. But here, too, things are changing. Climate risk doesn’t seem so hypothetical or far off to those gazing at red skies over San Francisco, fleeing their burning homes in the Australian outback, baling out flooded villages in the UK, or contemplating big writedowns in the value of their businesses (as the boards of Ford, VW, BP and Shell, to name but a few, have done). Here, a combination of consumer action, government policy, and financial market pricing are bringing the future into the present.”
He concluded by saying that governments and regulators will continue to put pressure on progress towards sustainable goals.
“So where does this all leave us? One thing is clear: there is a lot to be positive about – capital markets are innovating, and rapidly, in response to the very real rise in demand from clients, businesses, investors and public authorities to take climate risk and return seriously. And that innovation is beginning to drive some hard-edged price discrimination based on climate risks. In short, the hot air is cooling.”