Why financial regulations need an update in the era of the energy transition

April 18, 2024|Written by Matteo Gasparini
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As policymakers across the globe face up to the challenge of delivering results to meet the net-zero and carbon neutrality pledges of their governments, many have begun to question whether the tools, models and regulations are fit for the purpose of delivering the energy transition.

We know that a faster energy transition could save the world £12tn and prevent the dire effects of global warming. The focus therefore needs to be on removing barriers that might be holding this transition back.

Financial regulations are designed for specific objectives such as preventing financial instability or providing a “fair” representation of an entity’s financial position. Although there has been a longstanding debate around whether these regulations should be actively amended to consider societal objectives – such as climate change – the answer to this question may ultimately reside in the mandate of financial supervisors and regulators (and its legal interpretation).

But a different question is whether these regulations are unduly and perhaps inadvertently holding back the transition – and in so doing, also undermining their stated purpose. Holding back the transition may exacerbate climate-related risks in the financial system, but ignoring the structural change brought about by the energy transition may lead to an underestimation of the financial risk of portfolios (and an overestimation of the “fair” value of assets). Financial regulations need an update in the era of the energy transition.

Financial regulations are tilting the scales against renewables

Our research team at the University of Oxford looked at an important but largely neglected question; whether the existing financial regulations could be inhibiting the net-zero carbon transition. We found that this could be the case from an unlikely source. We found that an implicit bias exists in financial accounting rules – a key driver of the profitability of banks – which inflates the cost of divesting from high-carbon industries towards renewables.

Banks must account for risk in firms and investments. We found that under current accounting regulations, if the largest banks in the EU were to divest from high-carbon sectors and reinvest in other activities, we estimate that they would record, on average, losses equivalent to about 15% of their previous five years’ profits. This is due to an increase in loan loss provisions required to cover the higher estimated risk of low-carbon intensity activities, compared to high-carbon ones.

The cost of risk – the ratio of provisions to loans – influences banks’ behaviour and lending decisions. We find evidence that the average estimate of risk among EU banks is lower for carbon-intensive activities as opposed to low-carbon activities. This gap may create disincentives for financial institutions to divest their portfolios from high-carbon assets, and in turn, finance the green transition.

We posit that this is most likely due to the backward-looking structure of model-based risk estimates that do not adequately account for recent rapid changes in policy, the declining costs of low-carbon technologies, and other ongoing factors that are shifting the relative future risks of low-carbon versus high-carbon activities.

The problem of the backward-looking nature of model-based estimates is that they generally tend to rely on past historical relationships that may no longer hold in case of structural breaks such as the energy transition, as also acknowledged publicly by some regulators.

This issue is at the core of our paper and may go beyond the accounting framework analysed in our data. Prudential regulations leverage similar backward-looking models and shape economic incentives and the behaviour of financial institutions.

This is timely in light of the recent discussions around Basel 4, including the impact it may have on the energy transition. To work properly, prudential regulations should be based on accurate estimates of the risk of financial assets. There is a trade-off between the verifiability of backward-looking historical data and the relevance of forward-looking models.

We need a debate on whether purely backward-looking estimates remain fit for purpose in the era of the net-zero carbon transition. There is increasing evidence that risk estimates utilised for high-carbon assets (including fossil fuels) may be lower than low-carbon assets (including renewables) and this creates incentives that have implications for the primary purpose of the regulations and broader societal objectives.

The policy fix

For decades, people concerned about climate change have known that an important factor in a successful shift from fossil fuels to renewable energy will be getting the financial system behind the transition. Banks and the financial sector are among the most heavily regulated industries and for good reason. The key question is whether and how financial regulations should be updated considering structural changes brought about by the net-zero carbon transition.

The general lack of objective methods to estimate financial risk beyond using historical data is challenging, but an increasing number of useful tools are available. While imperfect, climate scenario analysis methodologies allow for a more forward-looking view of financial risks than historical data.

Some of these tools are already part of existing frameworks such as the IFRS9 accounting rules, but more climate considerations would be needed. Considering transition plans may also be increasingly useful to differentiate between firms that are taking actions to mitigate transition risks and those do not.

We have already seen various steps in this direction. For example, capital requirements may become increasingly influenced by forward-looking climate considerations. The European Central Bank expects banks to incorporate climate in its internal capital adequacy assessment process. The question remains around the speed and scale of these actions.

Model-based regulations are a prerequisite for the net-zero carbon transition. But, as we inevitably undertake this major economic transition to clean energy, the historically low risk of high-carbon energy becomes an increasingly unreliable predictor of their future risk. This has implications for financial regulations and broader societal objectives. A debate is needed on whether financial regulations should be updated to address this new paradigm shift.

This page was last updated April 18, 2024

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