What’s Missing from Financing Climate Mitigation and Adaptation

By Himani Phadke

At the COP21 climate conference in Paris, there was much debate about financing flows needed from developed to developing countries for climate mitigation and adaptation. It is clear, however, that if the transition to a low-carbon, resilient economy is to succeed, private-sector investments will play an important role. Private-sector investments now constitute up to 86 percent of global investment and financial flows, according to the U.N. Framework Convention on Climate Change.

Despite this essential role, investors in capital markets at the moment are operating somewhat blindly on the investment opportunities in these areas. They are also unable to assess systemic risks from climate change to their investment returns.

Ultimately, what they need is better information.

Financing change

For financial markets to direct capital toward climate change mitigation and adaptation, investors need to understand impacts from climate change on the companies in which they invest. These include not only the physical manifestations of climate change, but also the response of governments and populations to the issue. This response is shaping up in the form of disparate greenhouse gas (GHG) regulations and consumer demand shifts.

With better information, financial institutions need to integrate considerations of climate change into their core business. Fully factoring in impacts of GHG regulations in their credit-risk analyses, banks may redirect their loans from GHG-intensive activities to those that contribute to mitigation, such as renewable energy projects. Similarly, asset owners and managers can diversify their portfolios using information on climate risks and opportunities. Asset owners may also benefit from engaging with companies to improve performance on emissions reduction.

Indeed, recent studies have shown that ignoring climate-related impacts in financing decisions could have serious negative impacts on the financial sector itself. Lenders to carbon-intensive activities or to activities impacted physically due to climate change could face asset write-downs. Asset owners, including insurance companies, could face acute or chronic reduction in investment returns or asset impairment. This would impact the incentive fees — and therefore the revenues — of asset managers.

According to a 2015 study by Mercer, depending on the climate scenario, average annual returns from the coal industry, for example, could be lowered by between 18 percent and 74 percent over the next 35 years, with more pronounced effects in the coming decade. On the other hand, investments in the renewables sector could have average annual returns increasing by between 6 percent and 54 percent over 35 years.

Industry-specific implications

The impacts that investors face stem from similar risks and opportunities faced by companies in their investment portfolios. These include asset and operational impacts. As the Mercer study and the Sustainability Accounting Standards Board’s (SASB) research suggest, however, the severity, timing and manifestation of these impacts can vary markedly depending on the industry.

For large, direct GHG emitters, such as electricity generation and transportation, operational impacts arise from the cost of GHG regulations and fossil fuel price volatility. On the other hand, manufacturers of technology hardware, automobiles and other energy-consuming products are seeing impacts on revenues. These are occurring through shifts in consumer preferences and energy-efficiency standards.

Some industries, such as agriculture and real estate, are directly vulnerable to physical changes in the environment resulting from climate change. Companies in these industries may face losses in output or reductions in asset value without appropriate adaptation strategies.

According to one estimate, without adaptation, counties in the U.S. Midwest and South could face more than a 10 percent decline in crop yields over the next five to 25 years if farmers continue to sow corn, wheat, soy and cotton.

Industry-specific corporate disclosures on climate risk would then be a win-win for investors and companies. Financial institutions could integrate such information in their investment strategies and offerings, to manage climate impacts better. The performance of financial institutions in this regard would not only protect the value of their investments and their revenues, but could also provide critical funding for mitigation and adaptation.

The path forward

A key announcement from COP21 was the appointment of Michael Bloomberg, former New York City mayor and board chair at SASB, as head of a task force on climate change risk disclosure by companies. This industry-led task force was initiated by the Financial Stability Board, an international body entrusted with the stability of global financial markets.

Corporate disclosure of climate risks and opportunities is an essential policy complement to global carbon pricing signals. Together, climate disclosures and a price on carbon would facilitate reductions in GHGs and climate adaptation at the lowest cost.

From a policy perspective, better climate disclosures could go a long way by themselves toward desired climate goals, with or without a global carbon price. However, a global, or at least regional, carbon price-signal is important for the success of climate goals, as it would enable companies and investors to better plan for operational impacts. The price-signal can be in the form of a carbon tax or carbon credit price in an emissions-trading system. The landmark COP21 agreement, in which representatives from more than 180 countries submitted targets for lowering GHG emissions, sets the stage for such a signal to emerge. Such a signal would reduce business uncertainty, allowing companies in certain industries to obtain capital at a more reasonable cost than they would have otherwise.

This would still leave unknowns on financial impacts from physical changes to the environment. Corporate transparency on performance in this regard could help improve aggregate information on economy-wide impacts over time, enabling further policy action.

The establishment of a climate disclosure task force, then, is a crucial step in the right direction. Financial institutions can be agents for positive climate outcomes. At the same time, the climate risks they face could create systemic impacts. The focus on information relevant to investors is therefore welcome.

Image credit: Pixabay

Himani Phadke leads SASB’s standards-setting activities as Interim Head of its Standards Setting Organization. Since joining SASB in 2012, Himani has been managing SASB’s research on sustainability issues and their potential to affect corporate value. Himani has previous experience in financial consulting at LECG, London, and policy development at the UK Treasury. At the Treasury, she developed policy proposals for investment banking reform, with legislation based on these proposals being subsequently adopted by the UK Parliament. At LECG, Himani conducted financial analysis for consulting on business and regulatory issues in areas of valuation, litigation, transfer pricing, and climate change. Himani co-founded a renewable energy social enterprise, REwiRE, focused on scaling up energy access solutions for emerging markets. Himani has an MA in International Policy—Energy and Environment, from Stanford University, an MSc in Development Economics from Oxford University (UK) and a BA in Economics and Statistics from Mumbai University (India).