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Financial regulators challenging role in the transition to net zero

The decarbonisation of our financial system might sometimes need to be slowed down

Climate change is a clear and present danger to the wellbeing of current and future generations and a consensus has emerged in recent years that financial regulators have a role to play in supporting efforts to decarbonise our economies. While the focus so far has (rightly) been on the danger that the shift away from fossil fuel-reliance is happening too slowly, regulators also need to be cognisant of the risks to financial stability that come with an accelerated transition.

To understand the role of financial regulators in the climate transition, we need to recognise why the private sector won’t manage this risk appropriately by itself. One reason is “disaster myopia” – the idea that banks and other financial institutions may pay insufficient attention to risks lurking over the horizon. But high-risk strategies can be profit maximising even if the risks are known. This might reflect the expectation of a bailout. But it may also be driven by the herding incentives best articulated by “Chuck” Prince, former CEO of Citigroup, who on the eve of the Global Financial Crisis infamously told the FT: “…as long as the music is playing, you’ve got to get up and dance.”

Herding isn’t just a feature of booms. In a downturn, if my competitors are shoring up their balance sheets by shedding assets and hoarding liquidity, I will face pressure to follow suit. The result can be an individually rational but collectively damaging credit crunch and recession.

Is decarbonisation different to other financial risks?

The risks of climate change are likely to play out over a very long horizon by the standards of conventional financial risk analysis. Indeed, many of the most catastrophic effects are likely to be felt beyond the planning horizon of the boards of financial institutions – the “tragedy of the horizon” as Mark Carney has put it. Given this, the private sector is likely to adjust too slowly as there will always be a more pressing immediate concern to focus on.

What about herding incentives? There is undoubtedly a risk that financial institutions will retain exposures to carbon-intensive assets simply because their competitors are. But herding incentives can also operate in reverse. Reputational concerns and regulatory pressure could result in too fast a transition away from carbon-intensive sectors and into green ones.

Wouldn’t a fast transition be a good thing? Yes and no. The transition to net zero is the defining public policy objective of our time and urgent progress is required if we are to avoid catastrophic effects of climate change. But a disorderly exodus from lending to carbon-intensive companies creates risks of its own. There are two key things for financial regulators to keep an eye on. First, whether incumbent firms with big carbon footprints today but credible transition plans are still being well served by the financial system. As Sam Woods, head of PRA, has put it, “cutting off finance to these corporates too quickly could be counterproductive and have wide-ranging macro and societal effects”. Second, if we see a boom in green finance, is this leading to new risks being accumulated on bank balance sheets? After all, not every budding green start-up will blossom into a mature enterprise.

Financial regulators have a challenging role to play in the transition to net zero. They currently have their feet on the accelerator; helping to raise standards on climate disclosures and nudging regulated institutions to raise their game on measuring, modelling and managing climate risks. But periodically, they need to be prepared to apply the brakes, tackling the risks that might arise in a boom in green finance or slowing the withdrawal of credit or insurance services to carbon-intensive sectors. It would pay for regulators to do more to explain to the public this two-sided nature of their role. Doing so will make it easier for them to take uncomfortable actions when the time comes.

David Aikman is Professor of Finance at King’s Business School. A longer version of this article originally appeared in Macroprudential Matters.

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