10 May 2023

CEPR: Climate regulation and financial risk: The challenge of policy uncertainty

Climate risk has become a major concern for financial institutions and financial markets. Yet, climate policy is still in its infancy and contributes to increased uncertainty. For example, the lack of a sufficiently high carbon price and the variety of definitions for green activities lower the value of existing and new capital, and complicate risk management. This column argues that it would be welfare-enhancing if policy changes were to follow a predictable longer-term path. Accordingly, the authors suggest a role for financial regulation in the transition. 

Transitioning to a carbon-neutral economy requires structural changes. Fossil fuel-based energy needs to be replaced by renewable alternatives (e.g. wind and solar), and high-carbon activities such as heating need to be transformed (IEA 2021).

Public debate and academic contributions have been focusing on ways to implement the low-carbon transition (NGFS 2019), on the financial costs of a late transition (Alogouskofis et al. 2021), and on the benefits of early action (Gourdel et al. 2022). The debate is increasingly relevant for financial stability analysis and risk management (BIS 2021). For example, to inform climate stress tests, the Network for Greening the Financial System (NGFS) has developed climate scenarios showing higher costs and risks for high-carbon activities, in particular in a late or disorderly transition (NGFS 2021). While these scenarios take carbon taxation into account, they fail to consider how changes in financial regulation, both over time and across constituencies, affect financial valuations and investment levels.

Absent a coherent climate regulatory strategy, financial institutions and markets may not perform efficiently, as their role in reallocating funds and managing risks may be severely impaired. This should not be seen as a surprise: policy uncertainty adds risks, increasing the cost of capital for green investments and thus the value of postponing adjustments (Castellini et al. 2021).

Regulatory uncertainty and risk assessment

A set of climate policies such as a carbon tax and environmental and financial regulation, preferably coordinated globally, is needed to send the right signals to investors and elicit an effective response (Stiglitz et al. 2017). However, these are slow in the coming. Drivers of this policy uncertainty and limited coordination include:

• Swinging perception of climate risks by policymakers, also due to swings in public opinion (e.g. the gilet jaunes demonstrations in France, presidential succession in the US);
• New climate-related information reflecting availability of new data and improved methodologies, as well as the availability of new technologies that alter economic and policy trade-offs
• The global dimension of climate policy and the difficulties to reach consensus ¹
• Exogenous shocks, such as the current energy price crisis, which may inadvertently increase the attractiveness of regenerative energy sources or, by contrast, divert policies from formerly envisaged path of transition
• Poor quality of corporate carbon risk disclosure leading to unfair competitive advantage and greenwashing possibilities, ²  as well as different disclosure coverage at the regional and global level, contributing to contradictory and ambiguous information to investors ³...

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