Recalibrating responsible finance
Responsible Finance & Investment (RFI) Foundation C.I.C.
Building awareness, promoting research and encouraging convergence in responsible finance
Indicators used to measure progress in addressing challenges such as climate change and nature loss can be counter-productive if the metrics themselves become the focus. To address the expectations set down in the latest IPCC report, responsible finance needs to focus on how it can influence the actions of customers and other financial institutions.
During the nearly eight years since the Paris Agreement was reached, there has been huge progress on building awareness of the relevance of climate-related risks to the economy and to finance. However, the frame of reference for this understanding has often been very narrowly defined in reference to emissions sources and the financial risks facing emitters during the transition to a low-carbon economy. The?latest IPCC report on climate change?reiterates what has been previously mentioned in relation to climate change and amplifies the concerns about?nature loss, especially relating to?oceans and water.?
Natural capital and biodiversity have also risen on the agenda, but this has often been obscured behind the financial sector’s focus on climate risks, which is viewed on a binary sliding scale of higher transition risk, lower physical risk or lower transition risk, higher physical risk. The assumption underlying the focus on GHG emissions has been that a cost can be attached to a single item (emissions) to represent the driver for a ‘systemic’ risk, and that by providing the ‘missing price’ this can align financial institutions’ actions in the right direction.
Understanding the sources and full cost of the emissions that are driving climate change is undoubtedly important because it is integral to the worsening climate crisis. Great strides have been made in producing frameworks for integrating GHG emissions into decision-making, along with a lot of other sustainability-related data. But as the latest?report from the IPCC?makes clear, the impacts of climate change are permeating humanity through channels that are much more diverse than just climate transition risk or direct physical risks.
The overwhelming focus on GHG emissions is useful, and often favored because it is a tangible output of economic activity that is also a key input in climate change. It is also a datapoint that is readily quantifiable. However, it has also become a bottleneck for action on issues that transcend just climate change such as biodiversity and the blue economy. The possibility for GHG emissions to be measured makes them more appealing for financial institutions to manage and target, even if that leads to incomplete action, even judged on financial grounds.
Focusing so strongly on a single metric can create a short-sightedness that obscures other types of risk. For example, the crisis unfolding in some American regional banks began from a focus on data about what was immediately available and impacted near-term profitability. Banks and their investors were concerned that in a zero-interest rate environment, their profits were constrained by narrow margins.
领英推荐
Banks responded with strategies to marginally increase returns on their investments in a way that wouldn’t add credit risk. Yet, in the process they locked themselves into strategies that, as interest rates rose, became very brittle. They had replaced low but flexible profit margins with a structurally unprofitable set-up where they were paying out more on deposits then they were collecting from their investments. And when they acknowledged the issue, this created a crisis of confidence that created a cascade of losses, including some bank failures.
The way this relates to the issue of GHG emissions and financial institutions is that, when financial institutions take a ‘portfolio decarbonization’ approach, they try to calibrate their exposures to a specific climate trajectory independent of the bigger picture. In so doing they swap one type of measurable risk (emissions) for another that is more opaque and uncertain (long-term physical climate and nature risks).
The risk that financial institutions taking this approach are trying to mitigate is the direct financial cost from the price of a ton of GHG emissions rising towards its full value. The source of financial loss being managed is customers facing rising direct emissions costs in their operations that incrementally lower credit quality and could impair profitability.?
The more opaque and uncertain risk that’s being replaced through this strategy is more complex than the asset-liability mismatch outlined in the recent example of the banking sector’s duration risk, but it provides a basic structure, instead of a structural challenge of higher costs and lower income due to interest rate policy and the bank’s yield on its investment. In the case of climate and nature risk, the potential is for structural changes that impair the ability of the economy to produce the same level of returns with the same regularity as in the past.
From this perspective, the realization of more uncertain outcomes will require higher returns to deliver the same risk-adjusted returns or else result in lower risk-adjusted returns across the board. The impact is likely to be discontinuous at the customer level compared to aggregate impacts. More expectations of higher risk-adjusted returns by investors will coincide with a greater challenge for individual financial institutions to manage the full scope of climate and nature risks that will assert themselves as long as the ‘business-as-usual’ approach continues.
The IPCC report describes this in terms of: “Adverse climate impacts can reduce the availability of financial resources by incurring losses and damages and through impeding national economic growth, thereby further increasing financial constraints for adaptation, particularly for developing and least developed countries”.?
No amount of just calibrating financing & investment portfolios around GHG emissions, or refining a more and more granular reporting framework of the emissions, will mitigate this type of risk on its own. It requires a much more systems-wide analysis of how climate and nature risks translate into future economic risks, and how to translate this understanding into actions that produce deep change across the economy.?
Want to learn more about responsible finance in Islamic markets & Islamic finance??Subscribe?to RFI’s weekly email newsletter today!