EU policymakers have previously proposed a “green supporting factor” to encourage banks to lend to environmentally friendly projects. Sergio Scandizzo writes that while this proposal has proven to be controversial, the key arguments against the policy do not stand up to scrutiny.

A “green supporting factor” is a policy proposal that aims to encourage banks to lend more to environmentally friendly projects by lowering the capital requirements for such loans. It assumes that green loans have lower risks than non-green loans and therefore deserve preferential treatment in banking regulation.

However, this idea is controversial and has been criticised on the grounds that it could distort the market and undermine financial stability. There are broadly two kinds of objections: one, unsurprisingly favoured by bankers and traders, appeals to market efficiency, the other, favoured by regulators, relies on the objective quality of risk assessment.

Market efficiency

The first argument is that capital requirements adjusted for “greenness” would simply shift the funding of certain industries away from banks and towards other forms of financing. This would entail a somewhat higher cost of funding that will be fulfilled by institutions not subject to banking regulation. Consequently, the argument goes, the measure would distort the functioning of the market without having a real impact on the issue at hand (carbon-intensive businesses will still find access to finance, albeit at a marginally higher cost).

A corollary to this argument is that an appropriately high price for the right to emit carbon dioxide would instead give the correct incentive for the market to allocate capital in the most efficient way, by taking into account the social cost of carbon emissions.

This line of reasoning relies on two somewhat contradictory assumptions: that financial markets are indifferent to banking capital requirements and hence would find a way to finance carbon-intensive firms regardless of regulatory intervention, and that those same markets would instead react strongly to a different type of regulation, factoring in the presence of a carbon tax and presumably withdrawing funding from carbon-intensive firms in favour of greener ones.

While it is certainly the case that large companies who can access the financial markets directly would continue to do so, the likely higher cost of funding would have a negative impact, everything else being equal, on their carbon-intensive activities. Moreover, many companies, especially outside the US and of smaller size, rely on banking financing much more heavily and a green supporting factor would make a substantial difference.

On the other hand, while it is certainly the case that a carbon tax, conservatively estimated and universally applied, would be both a highly efficient tool to reduce overall emissions and the basis for a functioning market in carbon credits, it is far from evident that governments around the world have either the technical capabilities or the political will to implement it.

Although some level of carbon taxation has been in place for some time in several countries, only a very wide international agreement on the level of a carbon tax and on the way the related credits could be traded would be effective, as mobility of capital and regulatory/tax arbitrage would otherwise allow carbon-intensive businesses (especially the big ones who also have direct access to capital markets) to simply shift their operations to profit from more lenient regimes.

Furthermore, the level of carbon prices likely to support an orderly transition is likely to be much higher than current ones. The European Central Bank estimates “shadow” carbon prices for the Net Zero by 2050 climate scenario to rise from $200 in 2030 to $600 in 2050 (for reference, current levels across the world are nowhere near those numbers).

Scepticism about the credibility of such commitments are starting to creep into regulators’ reflections, as argued in a recent staff paper from the New York Federal Reserve, where it is questioned whether “policymakers would, for example, ever implement a carbon tax of a magnitude that would jeopardize the short-run debt-servicing abilities of high-emissions firms or dramatically reduce economic activity”.

Risk assessment

The second argument against a “green supporting factor” is that it might undermine risk assessment. In a dedicated report, the European Banking Authority explicitly advises against the introduction of “environment-related adjustment factors” within the prudential framework.

“Adjustment factors face both conceptual (e.g. overlap with existing Pillar 1 mechanisms) and operational challenges (e.g. calibration, need for international cooperation, granularity needed to differentiate exposures and capture forward-looking aspects such as individual transition plans) that complicate their design and implementation. The lack of strong evidence, data and methodologies for identifying and quantifying environmental risk drivers at this point in time would likely make the determination of the scope and size of adjustment factors uncertain. Overall, it is key to ensure that the calculation of [risk-weighted assets] is not distorted and to maintain risk-based capital requirements which fulfil their function as safeguards against unexpected losses.”

And yet, in the same document, echoing the European Central Bank’s “expectations”, the European Banking Authority calls for environmental and social risk considerations to be incorporated in rating assignments and risk quantifications, the latter including “adjustment of estimates” based on observed and reliable data. Adjustment of estimates will be of course as challenging for banks to devise as they are for regulators, and in any case, it is difficult to imagine that those developed by banks will go in a different direction than a “green supporting factor” or that the latter should be based on anything else than observed and reliable data.

The argument also reveals a contradiction between an idealised view of risk assessment as an objective technical process (“… it is key to ensure that the calculation of [risk-weighted assets] is not distorted …”) and a fundamental distrust for its constituting elements (“… lack of strong evidence, data and methodologies for identifying and quantifying environmental risk drivers …”) that are nevertheless expected to be relied upon by banks to incorporate climate considerations into their risk assessment. Banks will ultimately come up with the required adjustments, but each bank will do it on the basis of their own different methodologies, data and assumptions which supervisors will have in turn to individually assess and, if necessary, further adjust.

One could be forgiven for concluding that consistency of approach is here forsaken to avoid contaminating not only the supposedly technically neutral act of risk measurement, but also the equally hypothetical, non-political nature of banking regulation. In fact, the former contention is at best an aspiration while the latter is plain wrong.

On the one hand, risk assessment involves a broad array of subjective choices, particularly in the case of climate risk assessment. Furthermore, the way something is measured can affect outcomes when the same methodology is universally applied. For instance, several studies have shown that the widespread use of the famous “Black-Scholes formula” for valuing derivatives ultimately affected derivatives’ prices. This property of complex systems, also named reflexivity in sociological studies, has played a key role in all recent global crises, from the use of portfolio insurance in the 1987 crash, to the volatility and correlation models employed during the 1998 crisis, all the way to the role of measures of leverage (and fair value) during the great financial crisis.

On the other hand, regulation is an eminently political endeavour both because the financial system itself is a public good and because governments are banks’ stakeholders, who provide financial support at critical times. The administrative rule making by which governments exert their influence on financial institutions is what we call financial regulation. Government policies affect risk levels all the time and climate policies are no exception.

A ban on internal combustion engines (as foreseen by the EU from 2035), an increase in the price of carbon to several hundred euros per ton (as envisioned by the European Central Bank) and substantial subsidies on “green” industries (as already enacted in most countries) will all contribute to changing the risk profiles across industrial sectors. A green supporting factor should not be seen as being any different, were it not for the central bankers’ conviction that financial regulation is such a unique kind of policymaking that it should not be “corrupted” with public goals.

While it can be argued that there is insufficient evidence indicating higher or lower risks associated with loans linked to environmentally harmful or green activities, whether such risks will materialise or not depends on the implementation of an effective transition. Green activities will pose lower risks in an orderly transition scenario while carbon-intensive firms will face increased risks. Governments should facilitate the realisation of these risks to encourage an orderly transition in the economy toward a low-carbon trajectory.

Note: This article gives the views of the author, not the position of the European Investment Bank, EUROPP – European Politics and Policy or the London School of Economics. Featured image credit: Fahroni / Shutterstock.com