Can Financial Regulation Save the Planet?

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Scholars assess whether the financial sector should lead the transition to a low-carbon economy.

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If your house caught fire and your town had no fire department, would you consider calling your bank to come put out the fire? Of course not. And in a recent article, two scholars posit that asking banks to solve the climate crisis facing the planet could be just as foolhardy.

Dimitri Demekas, a visiting senior fellow at the School of Public Policy at the London School of Economics, and Pierpaolo Grippa, a senior economist at the International Monetary Fund, argue that having regulators impose too many climate-related burdens on banks could increase financial instability, exacerbate market volatility, and draw regulators into political roles without democratic legitimization.

Demekas and Grippa’s argument, however, might run contrary to current global demand. Calls for the financial industry to solve climate change are coming from many different arenas. The surge in demand for ESG-labeled investment funds demonstrates the pressure exerted by climate-interested shareholders and investors, according to Demekas and Grippa. Political leaders across the globe are also insisting on action by the financial sector.

Demekas and Grippa identify the different ways that financial regulators are responding to these demands, including, for example, increased efforts to measure climate-related risks within the financial system.

But financial risks from climate change can be difficult to measure in a consistent, accurate way that would support specific regulatory or policy action, according to Demekas and Grippa. They attribute this difficulty to the fact that climate risks often occur over long time horizons with varying and unpredictable degrees of severity.

One study’s results illustrate their point, finding that even in a worst-case scenario of climate change, the probability of bank default is uncertain and statistically variant. Demekas and Grippa assert that results such as these, with a wide range of unpredictable results, do not constitute a “firm basis for policy action today.”

Demekas and Grippa state that the lack of standardization around the integration of climate-related risks into policy action has led regulators to focus on identifying changes that will enable financial institutions to continue doing their jobs in a new low-carbon economy. According to Demekas and Grippa, financial institutions are right to remain focused on ensuring overall stability in the financial sector in a world focused on lowering carbon emissions and mitigating climate change.

Yet some observers say this is not enough. Even with the limited information financial regulators have, Demekas and Grippa acknowledge that some scholars believe the financial sector can and should undertake more climate-mitigating action.

According to Demekas and Grippa, these other scholars argue that financial regulators’ focus on maintaining financial stability and market integrity amounts to little more than “rearranging tables on the deck of the Titanic.” These critics would impose a duty on financial regulators and banks to take a more active role in the transition to a low-carbon economy.

One such action supported by other scholars involves incorporating environmental impacts into the calculation of risk-weighted assets. Banks could establish a brown penalizing factor, in which more capital would be required to loan to projects in “brown” sectors, such as oil drilling, and a green supporting factor, in which the capital requirements for banks to provide loans are lessened for projects in a “green” sector, such as solar power generation.

Proponents of actions such as these argue that the only barrier to financial regulators taking up the mantle of fighting climate change is “orthodox thinking.” However, Demekas and Grippa contend that these critics oversimplify matters. Demekas and Grippa claim that reducing the problem merely to financial regulators’ mindset ignores potential policy complications, problems with ineffectiveness, and large-scale blowbacks on regulatory competence.

They note that when a regulatory tool is used to pursue different objectives simultaneously, policy inconsistencies are inevitable. For example, implementing a green supporting factor to adjust risk would require regulators to address hypothetical unknowns. And according to Demekas and Grippa, lowering the risk factors for green investments without empirical evidence that green investments are actually less risky, could fuel a “green bubble.”

In addition, Demekas and Grippa claim that regulatory measures are “unlikely to achieve the massive shift in credit and investment flows required for decarbonization.” They point to recent model estimates that show that even a green supporting factor that halved the capital requirement for green projects would have a “negligible impact on overall credit growth” and a “very low impact on financing for the targeted transition projects.”

Furthermore, an aggressive pursuit of climate-mitigating regulatory measures could have unintended negative effects that extend beyond the financial sector, Demekas and Grippa argue. They caution that central banks and regulators could be criticized for disregarding the political process and overstepping regulatory authority if they move ahead on their own but legislators fail to follow their lead.

Demekas and Grippa recommend that financial regulators act in concert with relevant governmental bodies to provide needed oversight of the entire economy. Demekas and Grippa conclude that, although the financial sector possesses both the power and responsibility to help put out the fires related to the transition to a low carbon economy, ultimately it cannot direct the transition without government support.