Financial Policies and Climate Change: Time for the EU to Address Climate Risk?

1 WWF | Background paper: EU financial policies and climate change | April 2016

Financial policies and climate change: time for the EU to address climate risk?

WWF long term aim is to ensure that investment portfolios are ‘1.5/2°C compliant’ and contribute to the achievement of the Sustainable Development Goals.

1. The Capital Markets Union (CMU): the EU’s flagship financial initiative

In September 2015, the European Commission adopted its Action Plan on building a Capital Markets Union (CMU), with the aim of mobilising capital in Europe. This Action Plan points out that well informed investment decisions are needed to analyse and price long term risks and opportunities arising from the move towards a sustainable and climate friendly economy. The Action Plan also states that such a shift in investment can contribute to delivering the 2030 climate and energy policy objectives and the EU's commitments on the Sustainable Development Goals.

Unfortunately, the CMU Action Plan fails to mention Environment, Social and Governance (ESG) related risks and opportunities such as climate change. The only specific environment related issue included in the CMU Action Plan is green bonds, which are a niche issue that lacks any clear definition so far.

2. Climate change and wider Environment, Social and Governance (ESG) risks are already material for investors

Climate change is increasingly understood to present a series of risks to institutional investors. Climate change will inevitably have an impact on investment returns, so investors should view it as a new return variable. The scale of the potential climate impacts is huge. The Economist Intelligence Unit indicated that climate change could lead to average losses of €3.7 tn by the end of the century[1].

However, major fossil fuel companies continue to drive forward huge capital expenditure (capex) investments – that could become ‘carbon stranded assets’ according to the Carbon Tracker Initiative. This concept has been backed by authoritative organisations: the International Energy Agency warned that at least two thirds of all proven fossil fuel reserves need to stay underground to limit global temperature rises to below2°C[2]. A research from Kepler Cheuvreux finds that this may represent €24.6tn of stranded assets over the next two decades for fossil companies[3].

As shown in several meta-studies, ESG factors have a material effect on a company’s financial performance, especially when not addressed adequately. The climate issue is only one among many wider ESG-related risks that are becoming increasingly visible.

The disruptive economic impacts of the low carbon transition are already visible: large EU utilities bet against renewable developments and barely invested in renewable power: from 2008 to 2013 they lost more than half of their market value (a loss of €500 bn).

However there are also significant opportunities for investors: The 2014 Market Study by Eurosif[4] found that between 2011 and 2013, the increase in Sustainable and Responsible Investment was higher than the overall growth of EU assets (e.g. 91% for themes focused on excluding investments that ‘do harm’, compared to 22% total in 2011-2013). Mark Carney, the Governor of the Bank of England has also pointed out that as opportunities to invest in the ‘old economy’ decline new opportunities are emerging thanks to the technological innovations needed to underpin the low carbon transition.

3. The COP21 led investors to take more ambitious action

Leading investment consultant Mercer along with others have shown that climate risks to the economy are such that they should not be ignored by investors. As a consequence, investors are demonstrating an increasing willingness to act. This process has been accelerated inthe run-up to the Paris UN COP21 through the launch of new investor coalitions and initiatives:

• The Principles for Responsible Investment (PRI’)’s Montreal Pledge commits 120 investors, managing portfolios totalling US$10 trillion, to measure and publicly disclose their annual carbon footprint[5];
• The ‘Global Investor Statement on Climate Change’ gathers more than 400 investors representing US$25 trillion to pledge to increasing low carbon and climate resilient investments[6];
• The Portfolio Decarbonization Coalition[7] enables investors to act on the Montreal pledge by measuring, disclosing and reducing the footprint of their portfolios.

The COP21 agreement committed to keep global warming “well below 2°C and pursue efforts to keep it below 1.5 °C”. This is a commitment for immediate, more ambitious action.

4. A new context: financial authorities raise the climate alarm

Financial stability and climate risk has become a hot topic since 2015, with statements and reports on the subject multiplying – with several EU Member States moving forward unilaterally:

• In May 2015 the Swedish Government created a ‘green transition’ group, currently designing a programme of green finance reforms;
• In July 2015 France adopted an unprecedented law requiring institutional investors to disclose how they assess and manage climate change risks: it paves the way for other countries to follow suit.
• In September 2015, the Governor of the Bank of England raised concerns about the impact of climate change on future financial stability[8]. Chancellor George Osborne indicated that he wants the UK to be a global leader in green finance; the government is considering establishing a Green Finance Working Group to develop ideas;
• In December 2015, the Financial Stability Board announced at the global level the establishment of an industry-led Task Force on Climate-related Financial Disclosures to develop voluntary, consistent climate disclosure for use by companies in providing information to investors and other stakeholders;
• The German Government is actively working with ChinaG20 Presidency and the related G20 Green Finance Study Group;
• The European Systemic Risk Board (ESRB) warned in February 2016 in a new report of potential systemic risks if moves to a low carbon economy happen too late and abruptly and suggested enhanced carbon disclosure and dedicated “carbon stress tests”;
• In March 2016 the Dutch Central Bank called for more transparency on climate risks in a new report, including energy transition plans to help financial institutions assess climate risks;
• The Swedish Financial Supervisory Authority submitted a report to the government in March 2016 on how climate change may affect financial stability. It called on pension providers and financial sector to develop stress tests to capture risks to their portfolios from climate change;
• In March 2016, the Governor of the Central Bank of Finland also raised concerns on the potential effects of climate change on financial stability.
• In March 2016 the Financial Stability BoardTask Force on Climate-related Financial Disclosures issued its first report.

5. Next steps: How can the EU ensure consistency and leadership?[9]

• The financial risks of the transition to a low carbon economy are likely to be largely predictable and avoidable, and will be minimised if the transition begins immediately and follows a predictable path. This sets up a strong public interest case for policy makers to intervene and set up the regulatory frameworks needed to help the market anticipate the transition to a low carbon economy and facilitate an orderly transition.

• This provides a strong case for the European Commission to prioritise how the CMU can drive forward sustainable finance reform and, more concretely, deliver a clear framework that enables investors to assess and manage climate and wider ESG risks – hence requiring both that companies disclose clear and comparable ESG information and that investors factor it in their investment decisions.

• There is also a need to ensure that the reforms that emerge from the CMU will effectively facilitate and scale up investment in low carbon sectors and infrastructure. It would be a missed opportunity not to link the CMU and the estimated €2.5tn investment needed to deliver the 2030 EU climate and energy targets. Failure to do this would be contrary to the commitments made by the EU at the COP21 and with the UN Sustainable Development Goals to build resilient infrastructure and promote inclusive and sustainable industrialisation.

• The aim of the CMU – a single EU capital market – could be put at odds if Member States move forward unilaterally with national regulations on investments and climate risks – again providing a case for the European Commission to act and enhance EU-wide consistency.

WWF recommendations
Together with other stakeholders WWF’s work centres around three main areas of recommendations:

• Disclosure to enable investors to easily identify, assess and mitigate climate and wider ESG risks;
• Better surveillance, including climate stress tests to investors;
• Accelerate green infrastructure investment.

To provide concrete methodological and policy recommendations, WWF is part of the Sustainable Energy Investment (SEI) Metrics project (2015-2018) that aims to develop a climate performance framework and associated investment products that measure the exposure of financial portfolio to the new climate economy.

The SEI Metrics consortium is led by the 2°C Investing Initiative and comprises universities and public research laboratories (Frankfurt School of Finance, Universität Zurich, Centre International de Recherche-CIRED), financial services provider Kepler-Cheuvreux, the Climate Bond Initiative, the Carbon Disclosure Project and WWF.

In October 2015, the SEI Metrics project published a proposed methodology to assess the alignment of portfolios with the 2°C climate target: Assessing the alignment of portfolios with climate goals – Climate scenarios translated into a 2°C benchmark.

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1 WWF | Background paper: EU financial policies and climate change | April 2016

[1]The Economist Intelligence Unit (2015),The Cost of Inaction

[2]IEA, World Energy Outlook 2015

[3]Kepler Cheuvreux (2014), Stranded assets, fossilised revenues

[4]Eurosif (2014), European SRI Study

[5]

[6]

[7]

[8]His concerns were echoed by those from the Governor of the French Central Bank in December 2015

[9]This part builds on analysis from several stakeholders, notably E3G