Capital markets will play an increasingly crucial role in establishing a global carbon neutral economy, a Bank of England official said Friday, though financial markets need to incentivize climate disclosures and create a consistent framework in order for sustainable goals to come to fruition.
“Well-functioning capital markets are amongst the most powerful tools we have for turning the vision of a resilient carbon neutral economy into reality,” Andrew Hauser, executive director of markets at the Bank of England, said in a speech delivered to The Investment Association in London. “Cold hard price incentives that reward investments aligned with that goal, and penalize those which aren’t, are worth a thousand entreaties on the dangers of inaction.”
Hauser said capital markets can also help fund the $3.5 trillion annual investment necessary “for the foreseeable future” in order to cut greenhouse gas emissions.
In the past, progress toward sustainable investing was slow and financial markets struggled to reflect climate challenges in asset pricing. The reason for this, Hauser said, is threefold: financial markets are “notoriously poor” at pricing externalities that require all of society to work together, climate risk is a longer-term problem with an uncertain scale and, most importantly, a robust measurement of climate risk has been missing.
“What isn’t measured,” Hauser said, “can’t be priced, traded or risk managed.”
This year, however, Hauser said financial markets have begun paying more attention to green investments. For example, climate-oriented equity indices have outperformed the broader market by 2-5% so far this year, in part because economic activity has shifted away from travel and other fossil fuel-intensive sectors, and green bonds have also outperformed their conventional counterparts over that same period.
Additionally, governments have increasingly gravitated toward sovereign green bonds; the outstanding stock of those bonds currently stands at $80 billion, with Sweden, Luxembourg and Germany issuing their first green bonds in recent months.
Still, Hauser said three “key building blocks” are necessary to build a framework for sustainable investing: consistent, forward-looking climate disclosures, an increase in climate-linked instruments and asset allocation strategies that are “clear and credible” for clients and investors.
Hauser said it’s not clear whether a separate climate asset class will be permanently necessary — technology investment bonds and physical buildings equity, for example, are rare.
“But climate-linked instruments can be very helpful on the transition path, to give focus to the need for change, help meet specific investor needs, and provide a credible ‘put your money where your mouth is’ commitment from issuers,” he said.
Additionally, Hauser said it’s in companies’ best interest to begin disclosing climate performance sooner rather than later. When firms fail to provide their own disclosures, investors and rating agencies are often left to develop their own conclusions, which can increase equity risk premiums and overhead from dealing with investor inquiries on environmental issues.
Britain’s Financial Conduct Authority, as well as the European Union, are also considering making climate disclosures mandatory, which Hauser said will leave firms that aren’t ready scrambling.
Though governments have a role in overseeing and coordinating market-wide standards, Hauser said, many of the improvements necessary must be left to financial markets — “and rightly so, because we want the power of markets working to deliver climate change.”
Ironically, Hauser said, the fact that climate-specific tools are necessary “reveals the immaturity of financial markets’ relationship with climate risk.”
“In a world where climate risks were fully internalized, measured, priced and traded, there would be little need for dedicated climate financial infrastructure: climate risk would be factored into each and every risk and reward decision,” he said.
Hauser added, though, that the “Holy Grail” of an integrated, mature market where green bonds are just bonds and market pricing aligns with the costs of greenhouse gas emissions, “is a worthy goal. … But we are some way from that today.”