Walking the tightrope: Managing transition risk in a divergent Net Zero scenario

The International Energy Agency’s Net Zero 2050 initiative outlined the need to end financing for new oil & gas projects in order to keep climate change to under 1.5° C, but investors and regulators worry about the macroeconomic risks that could result from an unmanaged exit from fossil fuel projects rather than orderly transitions. Could regulatory action end up mitigating some ‘divergent Net Zero’ risks?

• Global ambition to curtail climate change to 1.5° C may trigger more macroeconomic and financial stability concerns than regulators are comfortable with
• Finance Watch, a European NGO, outlined a regulatory capital change they believe would be manageable and would better align incentives for financial institutions to consider transition risks
• The tricky issue of fossil fuel financing — which brings climate, financial stability and Just Transition considerations to the fore — provides a tangible example of the difficulty of mitigating investor- and financial institution-led ‘divergent Net Zero’ situations

One of the challenges financial institutions face, and regulators fear, in their approach to responsible finance is the potential for financial stability concerns to emerge depending on the speed of the transition of fossil fuel financing. The risks of energy supply disruption and disputes about the pace of future investments in existing fossil fuel assets often get combined with issues of new fossil fuel investment.

However, from the financial sector’s perspective, and that of regulators and investors, the ‘fossil or not’ debate is not the one that needs to be happening. Instead, the issue is contending with the least disruptive way for the financial sector to balance the consequences of shifts in the energy investment landscape that define the path between now and 2050.

On the one hand, considerations of climate change influenced the International Energy Agency to produce an important report on what Net Zero by 2050 would mean for energy markets. Their conclusion was clear that it would require “no investment in new fossil fuel supply projects, and no further final investment decisions for new unabated coal plants”.

On the other hand, the climate stress testing by regulators such as the Bank of England focused also on the financial stability risks that would come if the transition of finance moved much faster than the real economy could bear. The Bank of England expressed concern for “potential macroeconomic consequences if limits in the supply of finance and insurance to fossil fuel producers could outpace the new investment in sustainable energy alternatives and improvements in energy efficiency”.

Financial sector stakeholders such as the Institutional Investors Group on Climate Change also expressed concern about how investors approach decarbonization. Writing in a letter to the UK’s Transition Plan Taskforce, the IIGCC advised the task force to “Avoid encouraging ‘paper decarbonisation’ through the sale/divestment of carbon-intensive assets by setting expectations that companies and investors should achieve emissions reductions through transitioning their business models [such as] through stewardship/engagement”.

Following this line of thinking, European think tank Finance Watch looked at the cost for regulators to force action across the board through Pillar 1 capital requirements. Their new estimates follow a call in 2020 for regulators to step in for the largest, systemically important banks with risk weighting at 150% for fossil fuel financing (following standard risk weighting for ‘higher risk’ corporate assets) and equity-like risk weightings (1,250%) for new fossil fuel projects.

The financial impact of these policies, although they would affect different banks differently, on average would find a balance between focusing on real economy transition rather than divestment, while acknowledging that fossil fuel investment carries transition risk. Their recommendation is premised on what they described as a ‘climate doom loop’ where supervisory review and financial institution disclosures on their own are not enough to slow the growth of fossil fuel financing as required to meet global climate objectives, which leads to an unsustainable build-up of transition risk in the financial sector.

These are significant departures from current risk weights. Finance Watch estimates the total impact in terms of new capital required for the world’s 60 largest banks would be $157 billion to $210 billion. Although that’s a large absolute amount, in relative terms for the impacted financial institutions, it’s equal to about 5 months of earnings, because fossil fuel assets make up a small proportion of their overall assets.

For comparison, Finance Watch noted that “when banks increased their capital ratios to meet Basel III requirements after the financial crisis in 2008 — a much larger capital increase — large global banks did so by retaining earnings within an 18–24 month period, without a reduction in lending or total assets”.

As with anything, there’s no guarantee that regulatory capital changes would come into force without impacting the availability of financing needed for transition. One of the important considerations, which could be a stabilizing or destabilizing force, is comparing a capital requirement-related change (including how widely it is adopted and how synchronous the time frames) with the status quo.

Currently, the status quo has been slower than a regulatory-led change would imply; it has historically seen limited success in ending fossil fuel financing other than phase-outs of coal power. However, as more banks and insurers follow those such as Lloyds Banking Group and Munich Re and stop financing or insuring new oil & gas and financing the orderly phase out, regulatory action may become less disruptive than the type of bank-by-bank or country-by-country limits on financing new oil & gas projects.

If regulators set higher risk weightings for fossil fuel projects, this could act in a way to put more effort — and financing — behind transition-related investments. It offers an example of how ‘divergent Net Zero’ risks could emerge even in parallel with a globally coordinated climate process in the COPs. The substitution of ad hoc phase-outs with regulatory efforts to find a balance between emissions reduction and financial stability might provide a method for these types of divergent Net Zero risks to be mitigated effectively and in line with global Net Zero by 2050.

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