This post is the latest in our special issue: “Climate Change and Financial Markets – Risk, Regulation, and Innovation.” To learn more about the special issue and the work of the Global Financial Markets Center around climate change and financial markets, please read the special issue’s introduction here. And to review all The FinReg Blog posts that touch on climate change, go here.
While some investors may not yet care about climate change, many do. Investors and insurers need accurate information on important measures such as floodplains, fire zones, and deadly pandemics so that they can make informed investment decisions about future events and avoid the worst consequences of climate change on a financial investment. The problem is that investors and insurers do not know how to properly translate climate data into financial analytics. The increasing costs associated with the impacts of climate change are poorly reflected in financial statements and risk management frameworks across the globe. Likewise, future challenges and opportunities associated with climate policy are not fully appreciated.
Publicly available climate change information is incomplete and insufficient, leaving the financial sector vulnerable to climate-related risks, and low-carbon investment opportunities untapped. The Canadian Expert Panel on Sustainable Finance, the Task Force for Climate Disclosures, the UK Green Finance Committee, and the EU High-Level Expert Group on Sustainable Finance have all called for greater amounts of information on climate change. Yet, the link between climate data and financial data is a major problem that has not been fully addressed in the literature, either academic or professional.
The Canadian Expert Panel, for example, noted that Canada has to develop the essential building blocks needed to operationalise sustainable finance principles, including establishing a climate data hub as an authoritative source of climate information and decision analysis. Although it is clear that access to reliable and consistent climate data—and the ability to turn that data into relevant financial insight—is essential for sustainable finance, it is less clear how such a hub could be operationalised.
There is significant environmental data on portals such as Canadian Centre for Climate Services, Climate Data Canada, Canadian Centre for Climate Modelling and Analysis, Canada Climate Change Data Portal, the World Bank’s Climate Change Knowledge Portal, and the European Commission’s Copernicus Climate Data Store. Nevertheless, there is still a significant amount of climate data that is missing, and the data is scattered among multiple portals, readily accessible only to technically inclined professionals.
More importantly, none of these portals are economic or financially focused. This makes it very difficult, if almost impossible, for financial institutions to incorporate climate change into their investment analysis decisions. Making models (and reports) clearer for investors and policymakers is a necessary part of any new climate finance data hub. This will entail turning climate data into financial data, such as how many mortgages will be located on future flood planes due to rising water levels, or forecasting life insurance rates due to proximity to increased fire risks. This would allow capital to flow away from high-carbon and/or vulnerable areas towards low-carbon activities and climate resilient infrastructure. Better data equals better decisions.
Most literature paints a negative picture of the cost of moving away from a fossil fuel based economy to a low carbon economy. However, there is a lack of literature on the financial benefits of this change. The lack of a direct link between relevant data types, mainly climate and financial data, can be an impediment when looking to create a resilient risk management framework that addresses future climate impacts or health-related crises. Here is where the Canadian Expert Panel’s three recommendation pillars of tapping into transition opportunities, creating sustainable finance foundations, and scaling up of innovation can become a useful approach to address more climate-resilient risk management within the investment sector.
The Canadian Expert Panel states that “tools to translate that data into tangible impacts to a business, city or portfolio are virtually non-existent.” Similarly, the European Union is establishing an EU Observatory to help track and report on the EU’s sustainable investment needs as they state that better information is urgently required. I agree with these statements. For years clients asked me for sustainable products, or to give them some information about sustainable products. And yet, I was only able to provide them with very limited and incomplete information on such products. The information provided by most fund managers is of little value to most clients, retail and institutional. My research involves interviews with financial institutions and service providers on how they would like to see these data hubs operationalized, as I believe that any solution will necessitate a mix of private and government involvement. A climate hub would be a welcome addition as it will help all parties create information and products relevant for the future.
Issues with indicators and the need to incorporate “natural capital”
Once we obtain better climate financial data, we will need to transform this data into enhanced analytics. Business and financiers like the simplicity and certainty of numbers. In business language, “what gets measured gets done.” However, these analytical measures use formulae and indicators, which themselves create further problems. When you cannot get objective numbers, you create indicators, which are playing an increasingly important role in regulatory governance.
An indicator is a named, rank-ordered representation of past or projected performance by different units that uses numerical data to simplify a more complex social phenomenon. Comprising such aggregators as indices, rankings, and composites, indicators serve as second-order abstractions of statistical information and are used to evaluate performance according to a standard. Indicators address a visceral desire of policymakers to find mechanisms that can increase compliance with rules, a problem particularly acute in international economic law.
The problem is that indicators are often incorrect, or are based on incomplete data. Additionally, for many investments, especially for debt, the data is qualitative in nature. Thus, these qualitative data are turned into quantitative metrics, which are then further converted into indicators. Thus we need to fix the data quality problem and the indicator problem.
This lack of valid indicators creates a further problem. Traditional finance is based on financial and produced capital. That is, financial capital are traditional investment based assets such as stocks and bonds (equity and debt). Produced capital takes raw resources and builds ‘things’ such as buildings, roads, and factories. However, these definitions and uses of capital are incomplete in the 21st century.
There are three emerging concepts of capital that will be ever more relevant in a modern society. These three include human capital, the income earning ability of a well educated workforce; social capital, which is the relationships that are built on trust; and finally, the novel concept of “natural capital.”
Economists have long argued, with recent acceptance from the science and policy community, that natural resources are capital assets. Treating natural resources as capital in economic theory goes back at least 200 years to classical economic theories. Pricing of natural capital has remained elusive, with the result being its value is often ignored, and expenditures on conservation are treated as costs rather than investments.
Yet, markets for natural capital and the flows of ecosystem services they provide are often missing or incomplete, especially for natural stocks with weak exclusion such as common property or public goods, necessitating the integration of nonmarket valuation and capital theory to supply decision makers with valid prices. Nordhaus and Stern, for example, are critical of current climate economic theories and their applications. Yet, despite progress in the valuation of ecosystem service flows and the application of capital theory to natural resources, the value of natural capital often remains crudely measured at best.
Modelling climate-related financial risks
Insurance companies, pension funds, and ratings agencies use indicators to evaluate risk. But risk is based on underlying indicators, which themselves are opaque, often incorrect, or at worse, nonexistent. Although there exists a potential trade-off between risk and opportunity when it comes to climate change, the long-term systemic stake that pension funds hold might allow them to pursue or engage with innovations happening within the financial system. We need to transform these formulae and indicators into models that can accurately represent risk and guide decision-making.
A first step in this process is to standardize the definitions of green investments and climate-related financial risks with those of the TCFD framework or the EU’s green taxonomy. The TCFD recommends that the private and public sectors should address the transitional and physical risks that stem from climate change. For instance, transition drivers are those that create policy risks (like pricing of GHG emissions and compliance costs), legal risks (exposure to litigation and mandated disclosures), technology risks (disruptive markets and costs to deploy new technology as well as R&D), market risks (asset liability mismatch and rising energy costs) and reputational risks (changing consumer preferences and stakeholder concerns). On the other side, physical drivers of change can be either acute risks (like increasing severity of extreme weather events like hurricanes and flooding) or chronic risks (changes in long-term weather patterns, rising mean temperatures and sea-levels). A big factor in what is seen as the most urgent risk for investors will depend on the risk framework within which they currently operate. However, there is a need to better understand this. Here is where my research will fill the knowledge gap in creating a framework based on risk factors that are the most prioritized among investors like pension funds.
Institutional investors like pension funds are directly and indirectly pushing for transitional change, as seen with the dissatisfaction of current climate-related corporate reporting. Based on the financial volatility caused by the ongoing pandemic, risk-adjusted current and future investment decisions will be necessary if pension funds are to meet their fiduciary duty. Hence, a real need to access climate-related financial data and analytics exists in this community. The challenge lies in the fact that most climate data and indicators are new to the financial decision-making process, so a critical examination in their usage is required to prevent any greenwashing. For instance, the non-granularity of climate modelling or even confusion around which climate scenario to use can be a major hurdle for investors when they are operating at a global or sectoral level.
Financial-linked climate data, including credit ratings that reflect physical and transition climate risks, is forming part of the analysis of an investment opportunity. Low carbon projects are starting to be seen as being more attractive as opposed to high carbon projects. Pension funds also use metrics like liquidity, capital growth, volatility, diversification, or exposure to asset classes—and, more recently, the level of positive impact—in determining their interest and risk in an investment.
Innovative financial tools like green bonds and other responsible investments (RI) are creating the opportunity for investors to receive similar or even better financial returns, but with the added bonus of investing in green projects. One long-term asset class being highlighted for pension funds is the low-carbon climate resilient (LCR) infrastructure. This unique asset class will require some form of best practice guidelines that will build the foundations for management of climate-specific risks such as transition risk.
The full recommendations that will be published at a later date are the result of in depth empirical research of 50 global financial institutions. These institutions include banks, life insurance companies, property and casualty insurers, re-insurance firms, law firms, consulting/accounting firms, pension funds, and other firms involved in financial services. This research attempts to align the climate data results from the empirical interviews and make recommendations on the transformative metrics necessary to change the conversation from produced capital to natural or wealth based sustainability. However, for the purposes of this blog post, attached is a ‘Mindmap” of one potential structure of a climate hub, which would coordinate participation across actors within government, the financial services industry, and academia.
In simple terms, a skilled labour force working in a low carbon environment appears to be the key to future development in an increasingly globalized economy. Growth is in part about more efficient use of natural capital and investing the earnings from natural capital sources, such as minerals, into infrastructure and education. This investment then results in growth of total wealth. The use of non-renewable sources of energy are unsustainable, and these resources will eventually be depleted, but the income from these assets can be plowed back into other assets, to build an economy and support long-term growth.
The results should sound the alarm for global financial regulators to create better regulations around climate disclosure. The hub could combine climate and financial data, along with regulatory and reporting requirements, to create a ‘one stop shop’ for all climate financial analysis and reporting needs. Moreover, it must better incorporate materiality and disclosure requirements to standardize reporting. In addition, enhanced availability of data and analytics is key for not only financial advisors, but also for portfolio managers, insurers, and pension funds. It would allow for the creation of better investment products for retail institutional investors, illuminate instances of greenwashing, help regulators update standards and policies, and clarify an advisor’s duty of care and know your client requirements. The multitude of issues in climate investing cannot wait, and we must take bold actions to address them.
Keith MacMaster is a PhD (Candidate) and Lecturer at Schulich School of Law. This post is adapted from his paper, “Responsible Investing: Access Denied,” Banking and Finance Law Review (Vol. 34, No. 3, 387) and also available on SSRN. The research in this piece is part of a series of articles submitted for publication and under review on the need for better climate data, the need to update definitions of materiality, the need to update legal definitions of risk, and the need for institutions to operationalize the future of natural capital.