Pricing ‘always harmful’ activities soothes inflation and safeguards financial stability

October 5, 2022|Written by Jasper Blom, Seraina Grünewald, Ivo Mugglin, Rens van Tilburg and Jakob Vestergaard
Smoke pours from a slender an industrial red and white chimney stack against a deep blue sky
Lists of always environmentally harmful activities should be defined by central banks and financial regulators

Despite increasing interest among central banks and financial supervisors regarding climate change and biodiversity loss, financing of high greenhouse gas emissions and biodiversity loss continues. This threatens the very basis for price and financial stability.

The most effective way forward in addressing these environmental crises is rather simple: use the existing monetary policy and financial regulation instruments to correctly price the risks that the highest emitting economic activities, companies and sectors create. This would lead to a reduction of risks and a decrease in negative environmental impacts, and will encourage the transformation of the economy for which more capital will become available. It’s a win-win-win situation.

To initiate this, a list of high-carbon activities and exposure to transition risks is needed. In other words: a framework that lists assets which can be considered significantly or always environmentally harmful. As these are the riskiest ones financially speaking, developing such an ‘always environmentally harmful list’ falls squarely within the existing mandates of central banks and financial supervisors.

‘Wait and see’ approach risks disorderly transition

The economy is deeply embedded in the natural environment, so the resilience of the financial system and price stability depends on intact and functioning ecosystems. However, the actions currently being taken by monetary policy stewards to limit the twin environmental crises are inadequate and largely ineffective.

Most efforts focus on improving climate risk disclosures made by financial institutions, aiming to measure and quantify the default probability related to climate change and biodiversity loss, which transmits to overall financial instability risks. Conventional risk models are based on historical data and struggle to integrate the forward-looking indicators required for environmental factors that will degrade in the future.

The tragedy of conventional risk models is that, when environmental impacts finally materialise in financial risks, they will have passed the tipping points that make them irreversible. This is particularly worrying as recent studies indicate that it is very likely that various climate tipping points, such as melting of the Greenland ice sheet and Amazon deforestation, will be triggered earlier than expected. This means that there is no time to wait, and the next few years are crucial.

Despite some central banks, such as the European Central Bank, having the right ambitions, most currently opt to wait and better understand the risks. They view the status quo as neutral, think that their mandates do not require them to tackle climate change and biodiversity, and that intervening more directly than via disclosure requirements risks distorting the market.

Two burnt-out cars sit in open land surrounded by a few trees. The sun shines weakly through a smoky haze.
Drought and wildfires in California have cost billions of dollars and resulted in the loss of thousands of jobs © David McNew / Greenpeace

This approach misses the point that today’s asset purchase programmes have a heavy fossil-fuel bias and that renewable energy infrastructure is disproportionally hindered by interest rate increases. Insufficient action, or even inaction, results in a delayed economic transformation, which then requires larger interventions in future, greatly increasing the risk of a disorderly transition. Not requiring banks to hold sufficient capital now against climate risks means they will be destabilised when these risks materialise.

The Bank of International Settlements agrees that environmental collapse could render it impossible for central banks and financial supervisors to deliver their basic mandates of safeguarding economic stability. There is no financial or price stability on a planet that systematically overshoots the boundaries beyond which human civilisation is in jeopardy.

The current “wait and see” approach is failing and we are already witnessing the impacts of the climate and biodiversity crisis first hand, from Australian wildfires that cost farmers up to AU$5bn to the Californian drought which has so far cost almost US$2bn and lost 14,000 jobs. Insured losses from natural disasters have increased 250% in the last 30 years.  And current rates of nature loss could cost the global economy US$2.7tn every year by 2030.

Climate change and biodiversity loss are two sides of the same crisis. Not only are they interrelated, but they also reinforce each other, thereby increasing the pace at which environmental degradation advances. Despite this mounting evidence, banks, insurers, asset managers and other financial institutions continue to invest in and underwrite activities that are driving the environmental crisis and exposing the sector to serious future risks

Those responsible for monetary policy and financial regulation should act to address this market failure.

An ‘always harmful’ list in practice

Moves to define sustainable activities are underway, and the EU and Colombia have produced green taxonomies. But establishing what is “green” is a complex process and subject to intense debate.

Central banks and financial supervisors should focus on the economic activities, companies and sectors that have the highest negative environmental impacts and are considered to be “always environmentally harmful”. This is where the highest concentration of physical, transition and litigation risks can be found, resulting in substantial threats for price and financial stability.

A graphic showing WWF's framework for a list of always environmentally harmful activities
WWF’s framework uses three levels: economic activities, companies and sub-sectors

There is greater consensus around the fact that assets related to fossil fuels and deforestation are the primary drivers of climate change and biodiversity loss, and will almost certainly remain environmentally unfriendly in the future. As a result, it is far easier to develop and implement an always harmful list, yet none have so far been produced.

To bridge this gap, environmental group WWF recently published just such an initial list based upon three distinct analytical levels – economic activities, companies and sub-sectors. Each level can be used to provide either a more general or more granular risk assessment.

The economic activity level facilitates a distinction between those that cannot be retrofitted (such as solid fossil fuels) and ones with retrofitting potential (vehicle manufacture which solely relies on electric engines). This provides a more granular perspective on the transition risk, and could be the basis for adapting collateral frameworks and targeted refinancing operations so that always harmful activities are unable to benefit.

The company level distinguishes between businesses expanding activities that can be labelled always harmful, those that are transforming but not fast enough, and companies that provide proof of their effective transformation. This could be used as the basis for targeted adaptations of asset purchase programmes excluding always harmful companies, increasing haircuts within the collateral framework or increasing the risk-weighting in the capital requirements framework to 1250%.

And the sector level generates a more general risk analysis, useful for defining concentration limits or to modulate systemic risk buffers.

Debate and research must lead to action

In times of crisis, it is important to not lose sight of the relevant issues. Climate change and biodiversity loss are influencing price and financial stability directly, and the main drivers for environmental destruction are oil, gas and coal, along with deforestation-related activities. The current approach, focusing on transparency and trying to integrate environmental concerns in traditional financial models, is evidently not working.

It is more than 10 years since Carbon Tracker’s carbon bubble report and more than seven since Mark Carney’s speech on the “tragedy of the horizon”. Since then, there has been a lot of debate and research, but this has not benefited nature. Unsustainable trends continue and are expected to cross critical thresholds in the next few years.

WWF’s report – backed by more than 90 other organisations and economists – provides a framework to identify always environmentally harmful economic activities, companies and sectors. These are the elephants in the room which need to be addressed to spur the transition towards a more sustainable and resilient economy, and remain safely within the planetary boundaries on which our civilisation depends.

About the authors

Jasper Blom is a research fellow at the Sheffield Political Economy Research Institute, University of Sheffield. Seraina Grünewald is professor of European and comparative financial law, Radboud University. Ivo Mugglin is senior sustainable finance advisor at WWF Switzerland. Rens van Tilburg is director of the Sustainable Finance Lab at Utrecht University. Jakob Vestergaard is a lecturer in the Department of Social Sciences and Business at Roskilde University.

This page was last updated October 5, 2022

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