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Climate Finance: A Race to the Top

 4 min read / 

The pull of sustainable finance is so strong that European institutions are competing for the lead in innovation. After the European Commission’s Action Plan and recent legislative package, the Parliament approved the Scott Cato report, giving another boost to this European framework.

The Role of Central Banks

This time, the call came from Frankfurt as the European Central Bank joined the newly created central banks and Supervisors Network for Greening the Financial System (NGFS), established during the One Planet Summit in December last year.

Central banks, as public institutions, have a responsibility to taxpayers and an enhanced duty to be transparent. Coupled with the need to address the potential impact of climate risks on financial stability, the President of the European Central Bank, Mario Draghi, addressed a letter to the members of the European Parliament, stating that the ECB ‘recognises the challenge posed by climate change’. Draghi acknowledges that the correct pricing and supervision of financial risks stemming from climate change and environmental factors are essential to promoting sustainable development and preserving a well-functioning financial system.

The Way Forward

In 2015, the Financial Stability Board underscored the urgent need for greater transparency on climate risks and immediate action was taken by creating the Task Force on Climate-Related Financial Disclosures (TCFD). Now, in 2018, central banks and financial regulators have conjured up to produce a strategy on how to ‘green’ the financial system. The NGFS foresees three technical workstreams to deliver its strategy.

The first would address supervisory and micro-prudential issues, conducting a mapping of current supervisory practices for integrating environmental risks into micro-prudential supervision, as well as checking the information disclosure of financial institutions, highlighting risk differentials between green and brown assets.

A second workstream would cover macro-financial issues focused on quantifying risks to the macroeconomy and the financial system from physical transition risks associated with climate change. It would identify best practices and gaps to support policymakers.

A third one would focus in particular on scaling up green finance and look at how central banks and supervisors are currently incorporating ESG criteria in their operational activities. All workstream analysis will feed into the first NGFS progress report, due in April 2019.

Potential Mandate Ahead

Further evidence of policy progress also came from the other side of the channel this week, as members of the Environmental Audit Committee (EAC) concluded that large companies and asset owners such as pension funds should be forced into mandatory reporting on climate risks and be ready to do so by 2022. This work follows an inquiry led by the EAC and the report presented strong evidence that continued short-term thinking still dominates the UK financial system.

The report highlights how “structural incentives” in the UK investment chain currently encourage more focus on short-term risks at the expense of longer-term considerations. This translates into further exposure to long-term risks such as climate change.

The EAC also stresses that governmental requirements for reporting, which so far has been on a voluntary basis, does not go far enough in promoting efficient reporting behaviour. They call for a mandate to be instituted by 2022, following a ‘comply or explain’ framework.

Without a need for legislation, the report suggests that the government could achieve their goal by issuing new guidance under the Companies Act 2006 and make amendments to the Financial Reporting Council’s (FRC) Corporate Governance Code and UK Stewardship Code, as well as the Financial Conduct Authority’s (FCA) listing rules. A reference to France’s Article 173 was also included as a potential way forward.

Guidance Is Needed

Fergus Moffatt, Head of Public Policy at the UK Sustainable Investment and Finance Association, said: “The EAC’s report rightly draws attention to the disparity in guidance on how to consider climate change and wider environmental, social and governance risks between trust-based schemes and contract-based schemes. The Committee has given the FCA until the end of the year to rectify this situation by publishing such guidance – as recommended by the Law Commission – and I look forward to hearing how it intends to do this when it responds to the Law Commission later this month. It’s time for the FCA to break its silence on this crucial issue and explicitly recognise the financial materiality of climate change risks.”

One thing seems to be clear – when it comes to sustainable finance in Europe, one is looking at a race to the top.

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