Bank of England Governor identifies three areas of improvement in creating a sustainable finance system.
By Paul A. Davies and Michael D. Green
On September 24, 2019, the Bank of England (BoE) published two speeches given by its governor, Mark Carney, in which he calls for climate change-related risks and resilience to be brought into
the heart of financial decision-making. Both speeches — one delivered to the UN General Assembly and the other at an insurance industry event — outline three key areas of improvement that Mr. Carney identifies as being necessary to bring climate change into mainstream financial decision-making: disclosure, risk management, and returns. This blog discusses each of these three areas, as well as the policy options that Mr. Carney views as necessary to implement the required changes.
Comprehensive Climate Disclosure
Mr. Carney first discusses the importance of improving corporate disclosure of climate-related risks and opportunities. He highlights the Task Force on Climate-related Financial Disclosures (TCFD) as an example of a comprehensive, practical, and flexible framework for risk disclosure, and also notes that supporters of the TCFD control balance sheets totalling US$120 trillion (indicating potentially high demand for such a regime).
Adoption of the TCFD has been relatively high, with 80% of more than 1,100 companies in G20 countries now disclosing climate-related financial risks in line with some, if not all, of the TCFD recommendations. Mr. Carney acknowledges the high rate of disclosure, but suggests that a necessary next step will be to make such disclosures mandatory.
The UK government’s Green Finance Strategy, published in July 2019, states that the government expects all listed companies and large asset owners to report on climate risks by 2022. In addition, a joint task force is considering an appropriate route to mandatory disclosure of such risks. Aside from these UK efforts, there has been considerably less interest in mandatory disclosure internationally. Mr. Carney clearly presents his view that every country should introduce similar requirements.
Transformation of Climate Risk Management
The second necessary step change, according to Mr. Carney, requires that providers of capital improve their understanding and management of climate-related risks. Future changes in policies, technologies, and physical risks will likely lead to a significantly altered economic environment, and prompt reassessments of asset valuations worldwide. As a result, Mr. Carney believes that firms that embrace this change will thrive, whereas firms who fail to adapt at the necessary pace will struggle, or even cease to exist. The biggest challenge for regulators and investors will be to assess firms’ resilience to these risks and therefore their ability to respond to climate and climate policy changes.
Mr. Carney highlights the BoE’s supervisory expectations for the governance, management, and disclosure of these risks by banks and insurers as an example of what regulators can do to develop an essential risk management infrastructure. He also points to the fact that the BoE will be the first regulator to stress test its financial system against different climate pathways — a policy intended to bring climate-related risk awareness to the heart of the UK financial system. As with disclosure however, Mr. Carney opines that, for any meaningful impact to occur, this stress testing must occur on a global basis, and not be confined to the UK system.
Mainstream Sustainable Investing
As the final improvement, Mr. Carney calls for the bringing of sustainable investment into the mainstream — asserting that sustainable investment must do more than merely finance new “deep green” technologies. Mainstream sustainable investing must instead support all companies that are working to transition from brown to green.
Investment approaches such as “tilt” strategies, which give high environmental, social, and governance (ESG) stocks additional weight, and “momentum” strategies, which focus on companies that have improved their ESG ratings, have outperformed global benchmarks for close to a decade, acknowledges Mr. Carney. He views inconsistent measurements of ESG as one of the biggest obstacles that currently stands in the way of these strategies. In his opinion, directing investments appropriately requires a common ESG taxonomy that helps markets rigorously identify environmental outperformance.
Mr. Carney considers the EU’s Green Taxonomy and the Green Bond Standards as good starting points for a taxonomy, but feels they are too binary in identifying assets only as either green or brown. Mr. Carney proposes that a better approach would be to introduce a richer and more diverse taxonomy, with “50 shades of green.” He cites the recent initiative of the UN’s Climate Financial Leaders, to develop transition indices composed of companies in high-carbon sectors that have developed low-carbon strategies, as a “promising option.”
Mr. Carney’s recent speeches reflect the priority that the BoE and many other financial sector players place on addressing the impacts of climate change. By identifying three key areas that require a “step change,” Mr. Carney seeks to focus the industry on specific issues in which significant and meaningful improvement can be made in the short term. Mr. Carney believes that the actions of the BoE, whilst positive, are insufficient, and that the global phenomenon that is climate change requires a global response, which he hopes his candid words may help to catalyze.
Latham & Watkins will continue to monitor developments in this area.
This post was prepared with the assistance of James Bee in the London office of Latham & Watkins.
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