Climate change and financial stability

While emissions targets have been high on the political agenda, the financial stability of investments in companies that create the emissions has not received such widespread attention until recently. However, warnings are coming both from environmental groups and the financial sector itself that failure to take account of the carbon potential of investments could result in a financial crash.

Speaking recently on the subject of climate change and financial stability, Mark Carney, the governor of the Bank of England and chairman of the Financial Stability Board (FSB), said that climate change could have “potentially profound implications” for financial stability and the economy.

“Changes in policy, technology and physical risks could prompt a reassessment of the value of a large range of assets as costs and opportunities become apparent,” he said.

However, he noted that “risks to financial stability will be minimised if the transition begins early and follows a predictable path, thereby helping the market anticipate the transition to a two degree world.”

The issue, often referred to as the ‘carbon bubble’, centres on the way companies involved in the coal, oil and gas sector are valued. If we are to achieve a temperature rise of no more than two degrees centigrade over the next 40 years, only around 20-30 per cent of the world’s available oil, coal and gas reserves can be used, according to IPCC estimates, yet companies are currently valued as if all the reserves will be utilised.

This is not such an issue if there is a gradual movement away from investment in fossil fuels or a slow re-evaluation of these assets, but it has been suggested that an event such as a major commitment to limit use of fossil fuels or an environmental disaster could trigger a sudden drop in value of these assets and cause the bubble to burst.

This could have a severe effect on UK investors and the economy. The London Stock Exchange has the third largest greenhouse gas potential, with around 30 per cent of FTSE 100 companies related directly or indirectly to fossil fuels. The exposure of UK investors to these risks is “potentially huge”, according to Carney.

“From a regulator’s perspective the point is not that a reassessment of values is inherently unwelcome. It is not,” he said.

However, he said that a “wholesale reassessment” of values, particularly a sudden one, could destabilise markets, cause losses and lead to a “tightening” of financial conditions.

The risks in Scotland are also significant. The financial services industry in Scotland generates around £7bn for the Scottish economy and manages over £800bn of funds. It accounts for 24 per cent of all UK employment in life assurance and 13 per cent of banking employment. And in 2013 RBS was ranked eighth globally in terms of financing coal companies.

Some Scottish public sector investors have been weighing up the risk of these investments. Last year the University of Glasgow became the first university in Europe to commit to fully divesting investments in fossil fuels and the University of Edinburgh announced in May this year that it would divest from investments in three of the biggest fossil fuel producers within six months, although it will not divest all investments in fossil fuels.

Earlier this month, South Yorkshire Pension Fund became the first UK local authority fund to announce it is taking action on the climate impact of its investments. So far no Scottish local authorities have indicated that they will be following suit.

According to Friends of the Earth Scotland, Scottish local government pension schemes have a combined investment of £1.7bn in fossil fuels, representing 5.2 per cent of the total value of their funds. Strathclyde Pension Fund, which manages the benefits of over 200,000 public sector workers in the west of Scotland, is the biggest scheme in Scotland and second largest in the whole of the UK, with £752m invested in fossil fuels.

Both the Strathclyde Pension Fund and the Lothian Pension Fund recently examined the issue of the carbon bubble and concluded that there was no need for a change in investment policy. Among the reasons cited against divesting were the cost, the lack of a definitive list of fossil fuel investments and uncertainty around the timing of any regulatory change that might have an impact on the investments.

They also argued that divestment would not change levels of supply and demand for fossil fuel, but would reduce their influence with fossil fuel companies and potentially result in shares being sold to investors who were less concerned about climate change.

While Westminster’s Environmental Audit Committee considered the issue of the carbon bubble as part of an enquiry into green finance last year, there has been no similar enquiry by a committee in the Scottish Parliament. Other than a series of questions from independent MSP John Finnie about the investment of the Scottish Parliamentary Pension Scheme, there has been little public debate on a national level at all.

There is a certain inconsistency in Scotland’s approach to carbon – while the Scottish Government is working towards reducing Scotland’s carbon emissions by 42 per cent by 2020, at the same time the  Scottish Enterprise Oil and Gas Strategy 2012-20 aims to increase oil and gas sales to £30bn by 2020. This suggests a reliance on other countries increasing their carbon use, while Scotland reduces its own.

A similar inconsistency is reported in the 2013 Carbon Tracker publication, ‘Unburnable Carbon’ in relation to the UK as a whole, where it notes that conventional assessments of a country’s carbon footprint look only at the emissions generated within its borders, rather than emissions embedded in trade or investment flows.

“The bulk of those assets will not only be located outside the UK, but will also be consumed outside the UK,” it says. “But the carbon risks associated with these assets rebound back onto the UK market and those who invest in it, including the bulk of the savings and investments of its ordinary citizens.”

More transparency about the carbon potential of investments, as well as clarity over targets is advised to achieve a slow deflation of the carbon bubble, rather than a sudden burst.

Earlier this month the FSB recommended that the G20 set up an industry-led task force to develop voluntary climate-related disclosures that would help lenders, insurers, investors and other stakeholders understand the risks.

“Any efficient market reaction to climate change risks, as well as the technologies and policies to address them, must be founded on transparency of information,” said Carney. 

He added that a market in transition to a two degree world could be built only if information was available and the policy responses of governments and the technological breakthroughs of the private sector are credible.

“The more we invest with foresight, the less we will regret in hindsight,” he said.