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The impact of climate risk on investment decisions and disclosure law

The impact of climate risk on investment decisions and disclosure law

Climate change is predicted to cost 200 of the world’s largest companies $1 trillion over the next five years, according to a survey conducted by the charity CDP. But should the financial services industry be concerned? The answer is yes and for two fundamental reasons: the impact on investment and disclosure laws.

Ahead of the inaugural SustainableFinance.Live Co-Creation Workshop, hosted by Finextra Research and ResponsibleRisk, we spoke to Mark Hodgson, chief business officer at climate volatility AI platform provider Cervest, about the effect transitioning to a low carbon economy would have on investment choices and disclosure laws. Mark Hodgson is a Finextra Sustainable advisory board member.

Climate concerns and considerations

While no sector is wholly transparent on climate risk due to an abundance of regulatory reporting requirements and no standardised process, the CDP revealed that financial services institutions were the most forthcoming, accounting for 70-80% of estimated costs.

Pedro Faria, strategic advisor to CDP, asked: “The financial sector seems to be identifying more risks than the real economy. This raises the question: who is managing these risks?”

Hodgson references this survey and says that the CDP “believes that the climate crisis poses a systemic risk to the entire financial system.” Investments into or connected to land-based assets, as well as companies that rely on land-based assets for their businesses, must be reconsidered, as these are “much less secure and predictable than they once were.”

Further to this, disclosure laws must also be considered. “As the climate crisis escalates, governments are starting to take action through policy consultation and development. This is a good thing for broader societal protection and adaptation, as governments will bear the burden of a sizeable percentage of any future costs,” Hodgson explains.

While companies are starting to self-scrutinise their exposure to and impact on climate change, others are not fully engaged because “it is still not a priority over other pressures, it is still difficult to measure and therefore act and it is not yet mandated by disclosure laws designed to enforce a low-carbon economy.”

Hodgson predicts that in the next 12-24 months, businesses will be required to understand their carbon footprint better and make science-led decisions around portfolio choices, including supply chain impact and practices.

Defining green finance

Today, investors are attempting to define ‘green finance’ as a new investment area in parallel with the exponential growth of the green bond market. In addition to this, companies are being asked to demonstrate how a green, or sustainability, bond contributes to their low carbon transition strategy and investors are “scrutinising whether green bonds are new money or simply repackaged,” Hodgson says.

But should sustainable finance focus on the performance of companies or the performance of assets? Hodgson states that “it’s true that green bonds have shifted the spotlight to the performance of assets with positive environmental impact and economic value. There is also a question of what ‘performance’ means: is it financial? Or is it broader than that? Also, what does ‘performance of an asset’ mean and over what timeframe are we talking about?’

While these are all pertinent questions, Hodgson advises that the best course of action is to mimic the US’s incentivisation of green bonds, most likely through tax benefits.

“Improving the risk-return profile by increasing returns through public policies in the real economy such as feed-in-tariffs and carbon pricing and reducing risks through public financing tools such as guarantees, first-loss provisions and insurance” is beneficial, but the issue of a lack of consistent global standards is still significant.

In addition to this, as the market is still new, there is also a lack of quantitative data that proves that green bonds offer a price benefit and as the bonds are issued from the balance sheet of the issuer, there is no impact on creditworthiness, making the space “susceptible to claims of greenwashing.”

However, Hodgson explores how “if the market evolves in a way where the cash flows of a sustainable company or sustainable project is more resilient to risk and that is reflected in a stronger credit rating, then there should be a tangible pricing benefit.”

Confidence in the future

The creation of a universal green bond framework must be expedited, according to Hodgson and says that the European Commission’s recent proposals for an EU-wide Green Bond Standard is what is needed to increase confidence in the market. However, the question stands of who would be responsible for setting this standard?

Hodgson concludes by saying that while green bonds have helped “tap into the deep and liquid fixed income market to shift capital towards positive environmental impact,” fixed income instruments can also help other purposes, such as “alleviating poverty to lowering unemployment rates among disadvantaged groups.

“As a result, the green bond market has expanded to include social and sustainability bonds (which include both social and green.) We are also starting to see green and sustainability linked loans.”

Finextra Research and ResponsibleRisk will be focusing on sustainable finance in commercial banking at the first SustainableFinance.Live Co-Creation Workshop on Wednesday 4th December at 6 Alie Street in London.

Register your interest here for our inaugural event, where you can discuss what is driving the demand for sustainability and why companies are struggling to meet the benchmark set by the UN General Assembly’s Sustainable Development Goals (SDGs).

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