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The Interconnectedness of Environmental change and Capital Markets

The Interconnectedness of Environmental change and Capital Markets

Abstract

The recent pandemic severely impacted the financial markets which highlighted the intricate relationship that exists between the economy, capital markets and the environment. This global social crisis clubbed with the growing problems of climate change has changed investor perspectives regarding how they should allocate their money. Investors now realize that profit and sustainability do not need to be mutually exclusive.

This post explores the current gaps and the lack of preparedness of Indian systems towards a sustainable future and emphasizes the importance of financial institutions’ contributions towards sustainability efforts to prevent the exacerbation of climate change.

Introduction

The recent Covid-19 pandemic has shed light on the political complacency and denialism that exists in our society. The reality is that we have had the same approach towards climate change. We have wasted much time and going forward, we need to replace ideology and idiocy with engineering and economics. There is a need for clean electricity and climate-resilient infrastructure among others, all require investment, and that is where finance becomes crucial.

Until recently, financial institutions and investors only worried about short-term profits and did not take into consideration the other stakeholders that got harmed in the process. This system is now being rethought. The reality is eventually catching up with the financial markets as it is now evident that the financial markets, climate change and a global social crisis are all interlinked and, if these markets expect to be profitable in the long term, they have to invest in the solutions to the problems.

The quantum of disruption that climate change will bring to the financial system is already being predicted. “Should the global temperature change to 2⁰C, it will destroy trade routes, destabilize the capital markets, and potentially collapse the economies of many countries”[1] “Climate change may reduce global economic output by up to 3%, lead to up to a 20% reduction in GDP and displace up to 200 million people.”[2]  Global financial assets at risk would be US$1.7 trillion with a 1% chance of risk exacerbating to US$24 trillion, or 16.9%, of global financial assets in 2100.[3] If we look at India alone, we are on the brink of facing the worst water crisis this country has ever seen. The water demand will increase its supply by 2030, and 40% of the population and 75% of households will not have access to safe drinking water.[4] As per the 2018 Composite Water Management Index (CWMI), 6% of economic GDP will be lost by 2050 due to this crisis.[5] This is merely one of our problems among so many others that add to our nationally determined contributions (NDCs) to climate change. Similar calamities are also being witnessed worldwide, like South Africa, where they warned the world of ‘Day Zero’ as it will run out of water.[6]

The question is, given the already severe impact of the Covid-19 pandemic, will countries be able to afford the cost of the capital shift towards sustainable development? If this is the speed of deterioration of resources, what will be its economic and social implications, what will be the impact of this be on our food supply, will the cost of food increase due to natural disasters and water shortage, will it lead to severe inflation, poverty, and famine? How do we plan for economic growth if all markets are going to get affected by heat and other climatic calamities and financial institutions can no longer assess the long-term volatility of the markets and the future are highly unpredictable? Furthermore, even if there are solutions, how do we fund them?

This year, with the pandemic, forest fires, and other disasters globally, it is getting difficult to fund sustainability efforts. It is no surprise that the government’s financial resources are severely depleted, and the only place with a concentration of wealth today is the capital markets. This is where the nexus between capital markets and climate change becomes evident. “The International Energy Agency (IEA) has estimated that $1.1 trillion annually in low-carbon investments is required between 2011 and 2050 in the energy sector alone to keep temperature rise below the required 2°C.”[7] Since the governments cannot afford to finance this task themselves, the private entities have finally decided to provide the much-needed financial influx.

As of 2020, $40 trillion has been invested in global assets that work around sustaining the environment. The largest investment fund Blackrock has pledged to not invest in companies that present a high climate sustainability-related risk in order to increase long term shareholder value.[8] Furthermore, Institutional investments from the Montreal Carbon pledge, Global Investor statement on climate change amounted to 439 institutions managing $30 trillion have made commitments towards investing in Climate sustainable programs.[9]     

In November 2016, Global leaders came together to sign The Paris Agreement to achieve the collective goal of mitigating, adapting, and financing the stabilization of climate. They pledged to increase efforts to bring climate’s global mean surface temperature to well below 2⁰C above preindustrial levels. Several steps have been taken to promote this effort, for example, European Union regulators’ supervisory framework for climate change has necessitated banks to assess climate risk factors and business’ climate risk management structures before extending them credit.[10] USA financial markets are adopting the same.[11] This is rapidly being incorporated by many nations globally and has led to the formation of the Network of Central Banks and Supervisors for Greening the Financial System with over 60 members.[12]

However, the transition towards a sustainable climate system is going to be difficult. The transition will cause a rupture in high carbon industries worldwide, this disruption could then potentially have the ability to ripple across various other industries and thus causing financial instability. This may also have varied consequences such as global unemployment, deterioration of institutions, economic and social crises unless the transition is carefully crafted and balanced. To quote Larry Fink, “Even if only a fraction of the science around climate change is right, this is a much more structural, long-term crisis which is far bigger than the 2007-2009 recession.”[13]

The silver lining, however, if executed well, this transition to clean energy can be extremely profitable and generate upwards of $26 Trillion through 2030, further leading to an increase in employment and growth in world economies.[14] A profitable transition can be achieved by first analyzing regional climate vulnerabilities and defining specific activities that exacerbate climate risks.[15] Underdeveloped parts of the world should be looked at as empty canvasses for sustainable development and making them resilient to climate change. Regulators also need to use the power of finance efficiently. To invite in more finance from private entities, tax incentives should be provided. For example, in 2005, the USA gave a 30% tax reduction on investments in solar energy, which brought in $66 Billion.[16] Similarly, a heavy tax burden should be imposed on high carbon industries to discourage further investment in these industries. This will direct the finance in the right direction and build a positive outlook towards clean energy. This is also known as ‘Carbon Tax’. Similarly, subsidies on electric cars or solar panels need to be encouraged, to help in shifting our reliance from fossil fuels to green alternatives. 

However, these regulations are only as good as agencies executing them. The current system of ‘Jugaad’ in India and similar practices in different countries such as enterprises getting away with pollution, the non-effectiveness of Green Tribunals, corrupt practices in the system can no longer go on. Regulators and Governments need to start treating climate change as a systemic risk. There is a need for a national task force that can audit and enforce prescribed regulatory standards that companies should be compelled to follow. Though it is no surprise that government wallets are currently stretched thin, government or central banks must issue Green bonds to help fund sustainable development. This was initially carried out by the World Bank over a decade ago and was very well received by the investors. Not only will these bonds help contribute to our fight against climate change but also encourage private-public partnerships towards greener investments.   

Furthermore, we cannot wait for doomsday to arrive, and instead, preparations must begin now. Banks in Canada, England, and the Netherlands have started analyzing mock scenarios and ‘stress-testing’ their financial systems for plausible extreme calamities. This practice helps identify sector vulnerabilities and allows us to take remedial action that further helps in the integration of climate change in financial institutions.

To conclude, there is no doubt climate change is here and needs our utmost attention. However, the problem is not unsolvable. Regulators need to cautiously shift the financial trajectory towards sustainability, while not stifling innovation and employment in the public and private sectors. To achieve this, the financial sector can be a powerful ally if harnessed effectively. Climate change can be an opportunity in a world that’s adjusting to new normalcy today, and though the future may be uncertain, it remains within our power to influence it. [17]


[1] International Monetary Fund, “The Economics of Climate” (2019), https://www.imf.org/external/pubs/ft/fandd/2019/12/pdf/fd1219.pdf (last accessed on Jul 18, 2021).

[2]Mark Allen et al., “Climate change and capital markets”, Stanford Law (2015), https://law.stanford.edu/wp-content/uploads/2015/07/Climate-Change-and-Capital-Markets-FINAL-05-13-2015.pdf (last accessed on Oct 19, 2020)

[3]LSE Press release, “New study estimates global warming of 2.5 centigrade degrees by 2100 would put at risk trillions of dollars of world’s financial assets”, Grantham Research Institute on climate change (2016), https://www.lse.ac.uk/granthaminstitute/news/us2-5-trillion-of-the-worlds-financial-assets-would-be-at-risk-from-the-impacts-of-climate-change-if-global-mean-surface-temperature-rises-by-2-5c/ (last accessed on Oct 19, 2020)

[4]Manas Ranjan Hota, “India’s water crisis: Is there a solution?” The Financial Express (2020), https://www.financialexpress.com/lifestyle/science/indias-water-crisis-is-there-a-solution/2089860/ (last accessed on Oct 19, 2020)

[5] NITI (The National Institution for Transforming India) Aayog, Composite Water Management Index (August 2019), https://niti.gov.in/sites/default/files/2019-08/CWMI-2.0-latest.pdf (last accessed on Oct 19, 2020)

[6]Charlotte Edmond, “Cape Town almost ran out of water”, World Economic Forum, https://www.weforum.org/agenda/2019/08/cape-town-was-90-days-away-from-running-out-of-water-heres-how-it-averted-the-crisis/ (last visited July 18, 2021).

[7]International Energy Agency, Redrawing The Energy-Climate Map World Energy Outlook Special Report  https://unfccc.int/files/documentation/submissions_from_parties/adp/application/pdf/international_energy_agency._redrawing_the_energy-climate_map._world_energy_outlook_special_report._submitted_by_the_u.s.pdf (last accessed on Oct 19, 2020)

[8] Larry Fink, Letter to CEOs, BlackRock, https://www.blackrock.com/corporate/investor-relations/larry-fink-ceo-letter (last accessed on Oct 19, 2020)

[9] Ernst & Young Global Limited, Climate change the investment perspective (2016), https://assets.ey.com/content/dam/ey-sites/ey-com/en_gl/topics/banking-and-capital-markets/ey-climate-change-and-investment.pdf (last accessed on Oct 19, 2020)

[10] European Banking Authority, Report on management and supervision of ESG risks for credit institutions and investment firms (2021), https://www.eba.europa.eu/eba-publishes-its-report-management-and-supervision-esg-risks-credit-institutions-and-investment (last accessed July 18, 2021).

[11] U.S. Commodity Futures Trading Commission, “Managing Climate Risk in The U.S. Financial System”, Library of Congress (2020), https://www.cftc.gov/sites/default/files/2020-09/9-9-20%20Report%20of%20the%20Subcommittee%20on%20Climate-Related%20Market%20Risk%20-%20Managing%20Climate%20Risk%20in%20the%20U.S.%20Financial%20System%20for%20posting.pdf (last accessed July 18, 2021).

[12] Anwar, R.S et al., “Report on The Roles of ASEAN Central Banks in Managing Climate and Environment-related Risks”, Association of Southeast Asian Nations (2020), https://asean.org/?static_post=report-roles-asean-central-banks-managing-climate-environment-related-risks (last accessed July 18, 2021).

[13] Supra note 9

[14]Global Commission on Economy and Climate, The New Climate Economy (2018), https://newclimateeconomy.report/2018/executive-summary/ (last accessed July 18, 2021).

[15] Veena Ramani, “Addressing Climate as a Systemic Risk: A Call to Action for Financial Regulators”, Harvard Law School Forum on Corporate Governance (2020), https://corpgov.law.harvard.edu/2020/06/28/addressing-climate-as-a-systemic-risk-a-call-to-action-for-financial-regulators/ (last accessed July 18, 2021).

[16] Kevin Potter, Credits and Incentives provide green for going green, Deloitte – Tax at Hand (2015), https://www.taxathand.com/article/2689/United-States/2015/Credits-and-Incentives-provide-green-for-going-green (last visited July 18, 2021).

[17]Christine Lagarde, “Climate change and the financial sector”, European Central Bank, https://www.ecb.europa.eu/press/key/date/2020/html/ecb.sp200227_1~5eac0ce39a.en.html (last accessed July 18, 2021).

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