Green doesn’t mean risk-free: why we should be cautious about a green supporting factor in the EU

European Commision

EU flags in front of European Commission in Brussels (Credit: istock)

The European Commission announced this week that the EU is considering lowering capital requirements for sustainable financial products. This means that in future, EU financial regulators would treat green investments as less risky than carbon-intensive investments. So banks would need to hold less capital to buffer themselves against potential losses. The announcement comes as part of the Commission’s efforts to support sustainable finance and take action on climate change.

Creating incentives for banks and financial markets to make investments in green assets sounds advantageous for the green economy. However, using regulations designed to reduce risk in the financial system to mobilize investment should be approached cautiously.

A ‘green supporting factor’ would mean banks have less buffer against losses

In their July 2017 report the High Level Expert Group on Sustainable Finance (HLEG), which reports to the Commission on the opportunities and challenges of sustainable finance, raised the possibility of a ‘green supporting factor’. The regulation is designed to boost green investment but the HLEG noted multiple drawbacks.

The amount of risk banks have to factor in when making different types of investments is called ‘risk-weighting’. A higher risk-weighting means a bank needs to have more capital to insulate it from potential losses if an investment fails. These regulations are designed to make banks more resilient. Their aim is to avoid another financial crisis where governments have to bail out banks to keep them from failing.

A ‘green supporting factor’ would mean banks need to hold less capital when making green investments because those investments would have a lower risk-weighting. The Commission hopes that this would encourage sustainable investment, because some European banks have responded to higher capital requirements by reducing lending.

Some banks have been lobbying for the Commission to cut risk-weightings for green assets rather than increase them for carbon-intensive ones, because requiring them to hold more capital to buffer risks can lower their profits. But with less loss-absorbing capital, banks will also be more vulnerable if their investments fail.

Using risk-weightings to motivate investment should be approached with caution. Green isn’t necessarily safer than brown

In the long-term, the shift to a low-carbon economy means there will be significant changes to areas like energy generation. As with every kind of technological shift, there will be winners and losers in low-carbon sectors and in carbon-intensive ones, and it’s not easy to predict who will be the winners.

For instance, since 2015, more than 200 North American oil and gas companies have declared bankruptcy (mainly due to low oil prices), but so have more than 100 American and European solar companies between 2011 and 2015. In contrast, oil majors like Shell and Exxon Mobil have weathered low oil prices by increasing production efficiency and reducing overhead costs. The shift to low-carbon energy generation will have wider-reaching effects than low oil prices. Some companies may be able to adapt by diversifying their business operations. So it is not a foregone conclusion that the oil and gas sector will disappear. Particularly as oil and gas will continue to be part of the energy mix during the transition to low-carbon energy.

In the announcement the Vice President of the European Commission mentioned housing as one of the first areas that could qualify for lower risk-weighting.  Efficient homes have lower energy costs. In theory by spending less on energy green home-owners are better able to repay their mortgage. This makes the risk of them defaulting on payments lower. However there is little empirical evidence for this – just one study from the US. The lack of evidence suggests it is premature to conclude that green mortgages are categorically lower risk than standard mortgages. More data and research in the EU is needed, and we should be particularly cautious since European banks may already be exposed to risk from overheated property markets.

The case for a brown-penalizing factor is stronger. The financial sector is likely not properly taking account of the climate change risks associated with carbon-intensive assets. Increasing the risk banks need to account for in making carbon-intensive investments could go some way towards correcting this. However, there is still considerable debate about what the right level of risk weighting would be. There is also discussion of  whether other policy tools would be better suited to addressing the risk. More research is needed before moving to concrete policy proposals.

There is no clear evidence that lowering risk-weightings will encourage greater investment

Although the primary purpose of risk-weighting is to reduce the exposure of banks to risk, the Commission has used risk-weighting to try to encourage investment in the past. However, there’s no clear evidence that reducing capital requirements on investing in green assets will boost lending to green projects.

The European Commission introduced a ‘Small to Medium Enterprise (SME) supporting factor’ to decrease the risk-weighting for loans to SMEs. The aim was to encourage banks to lend more. However, there is little evidence that the SME supporting factor has been effective. The European Banking Authority’s initial assessment of the policy did not find evidence that it had significantly decreased borrowing costs or increased access to finance for SMEs.

In addition, interviews carried out by the Cambridge Institute for Sustainability Leadership with regulators and bank practitioners found that capital requirements only had a marginal impact on investment decisions for green projects. Other studies support the view that capital requirements do not significantly constrain bank lending across the economy.

Without robust evidence for a green supporting factor, the Commission and HLEG should look for other avenues to increase green investment

Giving in to bank lobbying could send the wrong signal to the financial sector. By supporting an unproven regulatory tool without a robust evidence-base, the European Commission could risk damaging the reputation of the concept of sustainable finance as a whole.

Instead of trying to increase the flow of finance towards green assets by hook or by crook, increasing investment should be approached in the light of existing evidence. Regulators can increase the resilience of the financial system through better understanding of climate risks. The HLEG should focus on identifying the most effective policies to scale up green finance, rather than the most politically palatable or convenient ones.

The views expressed in this commentary are those of the author and not necessarily those of the Grantham Research Institute.