BIS Papers Address Aspects of Climate Risk and Sustainable Finance
The Bank for International Settlements (BIS) published three papers that focus on the role of technology in combating climate change, the financial market pricing of physical and transition risks related to climate change, and the policy recommendations for sustainable finance, based on lessons learned on information governance.
The paper on climate technology addresses aspects such as whether the market channels capital toward (mature) technologies that have a higher potential to reduce CO2 emissions in the short to medium run, whether capital is geared toward companies that develop new technologies, and what is the performance of investments targeted at innovative climate tech companies. The key finding is that private investors channel more capital toward mature technologies with a high emission reduction potential (ERP). In contrast, funds invested by the US government are channeled toward nascent low-ERP sectors that receive less private capital. While taken individually, these sectors have a low ERP score, but together their impact is potentially significant. The paper also shows that, as the government supports these sectors and as the market expands, they attract more private capital. The paper traces the improvement in the allocative efficiency of private capital to an increase in the proportion of mature companies, a shift toward less capital-intensive software solutions, and more participation of better-informed investors.
The paper on pricing of climate risks summarizes the academic literature on the financial market pricing of physical and transition risks related to climate change. The paper notes that investors grapple with three major challenges when seeking to price climate risks adequately. First, the aggregate nature of climate risks limits the availability of risk-sharing arrangements and hedging instruments. Second, the high degree of uncertainty about climate risks and concrete policy actions to address them heightens modeling and measurement challenges. Third, the information available to investors about climate risks and their consequences is often incomplete or imperfect. The paper notes that opaque and unstructured methodologies make it hard for investors to extract information from ESG ratings and that ESG ratings and green innovation may not fully align. In the United States, firms with lower ESG scores, which are excluded from the investment universe of ESG funds, tend to be important green innovators. This misalignment might have implications for pricing and efficient capital allocation.
The paper on information governance in sustainable finance is related to the work undertaken by public bodies and stakeholder coalitions to develop guidelines that improve the information available to sustainable
finance investors. The paper discusses ways to enhance information governance in sustainable finance, a sector of funding markets that, in addition to financial returns, considers social and environmental benefits. Information governance is the set of regulatory provisions designed to mitigate conflicts of interest that could interfere with these flows. The paper reviews the common market failures in corporate disclosures and rating provision, along with the governance mechanisms used to address these issues; for instance, the market failures in corporate disclosures can be tackled by mandatory standards and assurance. The paper outlines the following key policy recommendations:
- Mandatory baseline disclosure standards to improve the comparability of sustainability-related information across firms
- Focus on historical developments instead of requiring forward-looking information, along with clear requirements to fully disclose negative events
- Different (proportionate) disclosure regimes for small and medium enterprises due to their inability to acquire and process the complex data
- Restriction of competition among rating agencies and giving more weight to ratings from agencies with a significant volume outside sustainable finance
- Enhancement of regulatory monitoring during booms, since the gains from lower standards are larger at such times and when issuers contribute a substantial amount of revenue to the agencies
- Provisions to ensure the integrity of commercial data repositories
Keywords: International, Banking, Climate Change Risk, ESG, Sustainable Finance, Climate Risk Pricing, Disclosures, Reporting, Basel, ESG Ratings, BIS
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