The urgent need to update financial regulations to support the global energy transition towards net-zero carbon emissions is becoming increasingly apparent. Current financial tools, models, and regulations may not be sufficient to meet the net-zero and carbon neutrality commitments that governments worldwide have pledged. While existing financial regulations aim to ensure financial stability and provide a fair representation of an entity’s financial position, there is a growing consensus that these regulations may inadvertently hinder the transition to a low-carbon economy and fail to account adequately for climate-related risks.
A significant discovery by a research team at the University of Oxford reveals an implicit bias within financial accounting rules that may inflate the cost of divesting from high-carbon industries in favor of renewables. The study found that if large banks within the European Union (EU) decided to divest from high-carbon sectors and reinvest in low-carbon initiatives, they would face average losses equivalent to approximately 15% of their previous five years’ profits. This loss arises primarily due to the increased loan loss provisions required to cover the perceived higher risk associated with low-carbon investments compared to high-carbon ones.
Barriers Created by Existing Financial Regulations
Under current accounting regulations, banks must maintain provisions to account for the risk of loans and investments. However, the average risk estimate among EU banks is lower for carbon-intensive activities compared to low-carbon activities. This discrepancy creates a financial disincentive for banks to divest from high-carbon assets and finance the green transition. The backward-looking nature of the model-based risk estimates prevalent in financial regulations is a key factor in this issue. These financial regulations, while historically grounded in maintaining stability, are now seen as potential roadblocks to necessary climate action.
The implications of these findings are far-reaching and underscore that existing financial regulations may inadvertently support high-carbon activities over low-carbon ones. Despite the intentions of ensuring financial stability and accurate risk assessments, these regulations fail to consider the rapidly evolving landscape of climate-related risks. As a result, the inclination to adhere to traditional risk evaluation models may have unintended consequences for the broader goal of achieving a low-carbon economy. Financial institutions face a dilemma where current regulations penalize green investments, making it challenging to align financial incentives with climate goals.
The Problem with Backward-Looking Models
The core problem lies in backward-looking models that do not adequately factor in the rapid advancements in policy, declining costs of low-carbon technologies, and other ongoing shifts that are realigning the future risk landscape of low-carbon versus high-carbon activities. As some regulators acknowledge, relying solely on past data may lead to underestimating the risks posed by high-carbon assets and overestimating those associated with low-carbon investments, thereby skewing economic incentives. This issue is exacerbated by the inherent resistance to change within the financial sector, where traditional methodologies have long been entrenched.
This principal issue is held against the backdrop of Basel 4 discussions, a comprehensive regulatory framework aiming to ensure banks are more resilient to financial uncertainties. Accurate estimates of financial asset risks are crucial for the effectiveness of prudential regulations. There needs to be an ongoing debate about whether these regulations, in their current form, are suitable for addressing changes of the magnitude presented by the net-zero carbon transition. The backward-looking data is highly verifiable, but its relevance is increasingly questioned in light of the forward-looking demands of the energy transition.
The Need for Updated Financial Regulations
There is a pressing need for updated financial regulations to reflect the new environmental and economic realities. These include objective methods to estimate financial risks that go beyond just historical data. Newer tools such as climate scenario analysis methodologies provide a more forward-looking perspective on financial risks, although they are still imperfect. Existing frameworks, like the IFRS9 accounting rules, incorporate some of these tools, but an increased inclusion of climate considerations is necessary. Differentiating between firms that actively mitigate transition risks and those that do not could also be essential.
Recent steps have been taken to integrate climate considerations into financial regulations. For example, capital requirements might soon be more influenced by climate considerations. The European Central Bank expects banks to incorporate climate concerns into their internal capital adequacy assessment processes. However, the pace and extent of these changes are critical. Slow adaptation risks perpetuating a system that fails to incentivize the shift towards a low-carbon economy effectively. Progressive steps are indispensable, yet the urgency of the climate crisis demands a faster and more comprehensive overhaul of financial regulations.
The Paradigm Shift in Financial Regulations
The pressing necessity to update financial regulations to support the global shift towards net-zero carbon emissions is becoming increasingly obvious. Present financial tools, models, and regulations might not suffice to meet the net-zero and carbon neutrality promises governments worldwide have made. Existing financial regulations focus on ensuring stability and accurately representing an entity’s financial standing. However, there is a growing belief that these regulations may unintentionally obstruct the move to a low-carbon economy and fail to fully consider climate-related risks.
A significant finding by researchers at the University of Oxford highlights a bias in financial accounting rules that could increase the cost of transitioning from high-carbon industries to renewables. The study discovered that if major banks within the European Union chose to divest from high-carbon sectors and reinvest in low-carbon initiatives, they would experience average losses roughly equal to 15% of their profits from the past five years. This loss is mainly due to the higher loan loss provisions needed to cover the perceived higher risk of low-carbon investments compared to high-carbon ones.