The European Commission will need to work harder to ensure efforts manage climate and wider environmental, social and governance (ESG) risk do not inadvertently scupper the Capital Markets Union initiative, argues Ingrid Holmes.
Ingrid Holmes is director at climate change think tank E3G. E3G’s report “Future Proofing the Capital Markets Union: Driving Sustainable Growth” is published on Monday 26 October 2015 at www.e3g.org.
In late September, Bank of England Governor Mark Carney unveiled the long-awaited results of the Bank’s probe into the risk posed by climate change and carbon bubble to financial stability. The Governor concluded that the while the financial markets are not at risk right now, the ‘perfect storm’ of physical risk to infrastructure from climate change events, value at risk from the carbon bubble, and the threat of fiduciary duty-related litigation does present a systemic risk to financial markets. In turn this means that the markets can’t simply be left to manage the fall out of the transition to the low carbon economy and that financial regulators do have a role to play in driving forward an orderly low carbon transition.
The Governor’s announcement trailblazes the findings of a broader review across G20 countries – undertaken by the Financial Stability Board (of which Mark Carney is the chair). The Board is expected to report its findings at the G20 summit in Turkey next month.
Against this backdrop, it is worrying that the European Commission’s recent Capital Markets Union Action Plan is silent on the need to build safeguards into this initiative, to manage systemic risks relating to climate change and wider environmental, social and governance (ESG) risks.
Of course, the Capital Markets Union initiative’s primary aim is to drive growth by better connecting savers and investors with opportunities to finance the real economy. But as a growing number of investors are increasingly aware that current business models and wider economic activity that assumes unlimited natural resources are not sustainable, the European Commission’s current stance seems out of kilter with wider political and market sentiment.
In 2014, EUROSIF – the European Sustainable Investment forum – published data showing socially responsible impact investing registered growth of 132% during 2011-2013. This figure is made all the more remarkable when you consider overall growth of the total European asset management industry was 22% over the same time period. Why would investors do this? Because more sustainable companies generally outperform less sustainable ones over the medium to long-term.
As the recent Volkswagen scandal over faked emissions testing demonstrates, this is not just wishful thinking. What businesses do and say on ESG issues (the Volkswagen scandal ticks all three of these boxes) does matter. Given that it was known that Volkswagen and other car manufacturers were cheating in emissions tests, obvious questions are raised about why it took so long for the financial markets to react.
It seems to indicate that current ESG risk management systems are inadequate and need further strengthening in the face of increasingly non-trivial financial risks. The Volkswagen scandal, which saw the company’s share value plunge 30%, is only the latest in a long line of examples of companies failing to fully manage environmental risks – and paying the price.
In June 2015, BP’s rating outlook was downgraded by Fitch Ratings because it expected lower crude oil prices, but also because of fines related to the Macondo oil spill, which are expected to cut cash flows and drive up debt. BP has already paid out more than $28bn for the Macondo disaster, and set aside a total of $43.8bn relating to the spill. Closer to home in the EU utility sector, the top 20 energy utilities in Europe saw over half of their €1 trillion market value wiped out in the period 2008 to 2013. The Bank of England’s study indicates we can expect to see more not less of this type of losses in the market unless governments and regulators act.
As financial regulation to manage these risks starts to emerge around the globe, the European Union will need to play a coordinating role in developing cutting edge financial regulation to manage these risks while expanding opportunities to connect capital to a sustainable real economy. This is likely to require:
- A mix of greater disclosure both by companies and investors to facilitate a shift toward mainstreaming responsible investment practices.
- Facilitating new approaches to investment through the Capital Markets Union.
- Effective risk management frameworks for infrastructure, some of which will need to be developed outside Capital Markets Union initiative.
The upcoming Financial Stability Board report to the G20 and agreement on a global climate deal in Paris give the European Commission legitimate reason to act. A next step could be to set up a Task Force to report to DG FISMA within 6 months on the materiality of climate-related risk to capital market stability and options for addressing this within the Capital Markets Union.
This review should draw on the existing evidence base available in the academic and publicly available literature but also draw on international experience of assessing and managing such risk in jurisdictions including the UK, France, Brazil and China. Consideration should be given to whether and how the European Systemic Risk Board could play a strengthened role in managing and monitoring emergent risk in the capital markets in conjunction with efforts led by the Bank for International Settlements and the Financial Stability Board at the global level.
From here, the Commission can build a legitimate mandate to look at wider ESG risk, and the means to help capital markets identify exposure. Initial analysis and best practice from a number of EU member states suggests that this can be achieved. In doing this, Europe can move on and learn from the lessons of Volkswagen and other corporate ESG scandals.
Better information and oversight opens opportunities to create capital markets that are well informed, have investment practices that are transparent and accountable, and institutions that are flexible enough to make the real economy investments needed to deliver a climate-resilient economy. That is something that investors, savers and society can get behind. That’s a Capital Markets Union worth having.