Fossil fuel financing will only end with capital regulation

The dominant approach to decarbonising financial flows has been to gently encourage private sector banks and capital markets to disclose and voluntarily reduce their climate exposures. The result would be improved price discovery and a smooth net-zero transition without the need for the heavy hand of the state.

This consensus is now unravelling. The latest domino to fall is the world’s second largest asset fund manager, Vanguard, which recently announced it would be withdrawing from the two major global financial alliances formed to drive forward this market-led decarbonisation paradigm: the Net Zero Asset Managers Initiative (NZAM) and the Glasgow Finance Alliance for Net Zero (GFANZ). Vanguard has $7.1tn assets under management and more than 30 million customers.

The chief intellectual architect of the approach to financial reform, former Bank of England governor Mark Carney, has also implicitly admitted the limitations to market-led initiatives, stating at Cop27 in November that governments should align financial regulation with the net-zero transition. This followed GFANZ being forced to drop its requirement for members to sign up for a UN emissions reductions campaign – Race to Zero – prior to Cop27 in the face of threats of major investors to leave the alliance.

GFANZ members have continued to fund fossil fuel activity in the aftermath of Cop26 held in 2021, including bond issuance for coal companies maturing into the 2030s. A recent survey found that less than 40% of financial institutions have disclosed long-term net-zero targets. Of these, only 2% have been translated into interim targets, of which just 1% are backed by scientific evidence. Another comprehensive study found that only 49% of climate-related disclosures were of use to market participants in assessing and pricing climate risks.

Central banks cite lack of data as a reason for lack of regulation

The fundamental challenge is the disjunct between financial firms’ time horizons, their approach to measuring risk and the reality of climate change dynamics. Their financial risk models typically extrapolate from past data and don’t generally forecast much further than three years into the future. Yet climate change has no historical precedent, and the most severe impacts will be felt in decades, not years. This “tragedy of the horizon” was recognised by Carney in a speech in 2015.

Central banks across the world, including the Bank of England and the European Central Bank, are increasingly cogniscent of this problem. But they remain stuck in the “information problem” paradigm, citing a lack of data about climate risks as a reason to persist with research – in particular detailed scenario analysis and stress tests – prior to, or instead of, concrete regulation.

The problem is that climate and other forms of environmental change are subject to tipping points. These occur when cumulative changes push a biophysical system past a critical threshold and into a different state of functioning with potentially catastrophic and irreversible consequences.

A recent scientific paper found that six climate tipping points become likely within the Paris Agreement range of 1.5-2°C warming, including the collapse of the Greenland and West Antarctic ice sheets, the die-off of low-latitude coral reefs, and widespread and abrupt thawing of permafrost. These events cannot be assigned a meaningful risk or indeed a price at the level of individual financial institutions.

Given this reality, there must be more appreciation of the trade-offs between knowledge building and risk materialisation. As Sylvie Goulard, deputy governor of Banque de France, said recently: “We need to understand as central bankers that the best risk mitigation strategy is to do everything in our power, early enough, to ensure we remain within planetary boundaries.”

Precautionary capital regulation is required to avoid planetary system collapse

It’s therefore time to move beyond voluntary or even mandatory disclosures, scenario analysis and supervisory discretion towards mandatory rules to reduce investment in fossil fuels.

Capital requirements are the obvious tool for better aligning the financial system with these systemic climate risks. Requiring lenders to hold one dollar in cash for each dollar invested in fossil fuel-intensive activity or extraction – a one-for-one rule – would mean that, at very least, the taxpayer would be protected from a collapse in the increasingly volatile fossil fuels market, whether caused by climate-linked catastrophes or the march of renewables.

But the systemic risk posed by continued financing of fossil fuels requires macroprudential policy interventions. The time horizon problem could be dealt with by dynamically aligning prudential policy to the climate transition via imposing variable capital risk weights on all fossil fuel-related assets, reflecting the global overshoot from a safe carbon budget within a 1.5ºC scenario.

A climate systemic risk buffer could also be applied to those institutions with the largest exposures to climate risk. This would both enhance financial system resilience and internalise the systemic risks created by such institutions.

As with windfall taxes, the big extractive companies argue that restrictions on fossil fuel investment could act as a curb on their potential investment in renewable energy. Yet, as the huge share buy-backs and dividend payments which the big energy firms have conducted in recent times demonstrate, there is little evidence this argument holds true. Rather, it’s obvious that making fossil fuel investment less financially attractive should push investors toward renewables.

Climate change is a ruin problem which threatens complete system collapse, exposing the earth system to irreversible harm with negative outcomes which may have infinite costs. This requires a precautionary financial policy in the face of the radical uncertainty posed by climate change. Rather than measurement as a prerequisite for management, we need regulatory action informed by science that, however imperfectly, steers us away from catastrophic climate tipping points.