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Source: This post is based on the article “Getting finance onside for climate” published in Business Standard on 30th August 2021.
Relevance: Role of finance in alleviating climate crisis.
Synopsis: Climate crisis demands enormous economic and societal changes. The challenge is manageable. But if it is to be managed well, finance must play its part.
The world has finally awoken to the need of securing a rapid transition to a green economy. Finance will play a pivotal role in that process. But while some financial institutions have done their part, far too many continue to provide capital to the fossil-fuel industry and support other parts of the economy that are incompatible with a green transition.
Such type of financing activity is irresponsible.
Creation of stranded assets
Many of the investments currently being financed in the fossil fuel industry are long-lived. For example: Discovering, developing, and fully exploiting a new oil field takes decades. This means they stretch well beyond the time in which the world must become carbon-neutral. As such, these projects almost certainly will become “stranded assets”.
- Stranded assets are holdings that have lost their value and usefulness amid the fight to save the planet.
Impact of creation of stranded assets
Losses suffered in the form of stranded assets pose a risk to the investor and, potentially, to the economic system and the planet.
- Lobbies to fight green transition: Most owners of stranded assets will selfishly fight to exploit their holdings no matter what, hence, financing for these investments creates an adverse political dynamic. Powerful lobbies, heavily invested in such projects, will fight the green transition, because otherwise they’ll be the ones left with stranded assets.
- Demands for compensation: Moreover, if the transition succeeds, these same groups will demand compensation.
- Deploy regulatory tools: Since markets are short-sighted and often fail to account fully for key risks, the obligation to ensure financial stability lies with those overseeing the economy, including central banks.
- Disclosure of climate risk: It should be obligatory to disclose the full climate risk of any fossil fuel-based project to the regulator. Risk must include not just physical dangers, but also direct and indirect financial risks based on various scenarios listed in the IPCC reports.
- Smooth transition: We need a smooth, efficient transition to carbon neutrality, with gradual adjustments in asset prices. For this to happen, finance must not only stop providing funds for investments that destroy our environment but also provide funds for the investments needed to move us in the right direction.
- No subsidization: Those investors who continue to make investments in fossil fuels should not effectively be subsidized by the public through the deductibility of losses.
- Compensation guarantee: To encourage investments that are based on a high carbon price, governments could issue “guarantees” that if the price of carbon turns out to be lower than expected in, say, 20 years, the investor will be compensated. This would function as a kind of insurance policy, pressing governments around the world to uphold their commitments under the Paris climate agreement.
Green development banks
These and other similar policies will assist the green transition. But even then, the private financial sector is unlikely to do enough on its own. Hence, to help fill the gap, green development banks have already been created in many jurisdictions, including the state of New York. In some other countries, existing development banks’ mandates have been broadened to include green development.
These institutions are making an important contribution not just in providing finance, but also in assisting with the design and structuring of the green projects themselves.