What would it mean to green the UK financial system?
To deliver a Green New Deal we must rethink the role of government, the Bank of England and financial institutions.
The decarbonisation of the UK economy is now more urgent than ever. Fiscal policy, change in consumption norms and regulation all have a key role to play in addressing the climate crisis. But a rapid decarbonisation will not be possible without a radical transformation of the financial system as a whole.
Our financial system provides many loans to carbon-intensive activities, invests only partially in green projects and supports our unsustainable ways of living. In short, our financial system is not fit for purpose. What we need is a financial system that can support a Green New Deal. So what exactly would that look like?
First, the financial system should have green banks at its core. This shouldn’t be limited to a re-nationalised Green Investment Bank. A financial system intent on decarbonisation would need to include small banks that have ethical targets, support local communities and are active in financing projects in renewables and energy efficiency. A strong support of these banks could potentially reduce the power of the larger banks that provide the vast majority of carbon-intensive loans.
Second, the Bank of England’s monetary policy should become greener. Over the last few years, the Bank of England and other central banks around the globe have implemented Quantitative Easing (QE) programmes. However, researchers have shown that the corporate QE programme implemented by the Bank of England has favoured sectors that contribute more to the generation of greenhouse gas emissions.
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This needs to change. Instead of continuing a QE programme based on criteria that support the status quo, the Bank of England could easily shift to exclusively buying green bonds with the help of a green QE programme. Through this, it could actively lower the cost of funding for green projects that rely on bond finance, making green investment more viable across our society.
The Bank could also adopt a more climate-aligned approach to the way that it lends money to commercial banks. In the current system, which relies on the so-called ‘collateral framework’, banks can borrow from the Bank of England by using specific financial assets as collateral. The assets that can serve as collateral are determined by the Bank of England based on a number of criteria reflecting credit quality. However, despite the caution and due dilligence put into assessing this collateral, the Bank of England’s set of criteria fails to take into account the role of climate change.
How then could the collateral framework be realigned against climate crisis? One way would be to exclude loans or securities linked with projects that generate a large amount of greenhouse gas emissions from the collateral framework altogether. In addition, the Bank of England’s framework could prioritise assets related to low-carbon projects.
Crucially, the greening of monetary policy cannot be successful without a clear taxonomy on what constitutes a “green” and a “brown” asset. The European Commission has recently worked on the development of a green taxonomy. While this is a step in the right direction, there are still challenges to be worked out with this “green” taxonomy, and just as importantly, policy makers have not yet clearly defined a taxonomy for “brown” assets, a task which remains as urgent as ever.
Another step that would be useful would be for financial regulators to penalise banks that provide too many carbon-intensive loans. One way would be to ask commercial banks to hold more capital against such loans. This could restrict the expansion of “brown” credit.
Financial regulation could also incentivise banks to provide more green loans through lower capital requirements. But this would require careful consideration because it could undermine financial stability.
With that in mind, we already know that climate change is very likely to have an adverse impact on financial stability. As a fourth measure, banks, pension funds and insurance companies should not be allowed to ignore the risks that can lead to climate-related financial fragility.
Financial institutions should disclose such risks using widely accepted methodologies, rather than internally defined criteria. This would allow financial regulators to assess the exposure of these institutions to climate risks and act upon this. It would also allow investors to be aware of the greenness/brownness of their portfolio and potentially reallocate their investments accordingly.
Some steps in this direction have been made. In 2017 the Task force on Climate-related Financial Disclosures (TCFD) was established. The TCFD, which has been actively supported by the Bank of England, intends to develop methodologies that will allow financial companies to consistently disclose climate-related risks. However, their current approach is to argue that this should be done on a voluntary basis. It seems clear, at this point, that the disclosure of climate-related financial risks should be mandatory.
Overall, a radical green transformation of finance is feasible. However there’s no doubt that it remains a very challenging task. Implementing the proposals outlined above will require a radical rethinking of the role of the government, the Bank of England and the financial institutions in a world where environmental breakdown is already on course. We must be ready to take up the challenge.
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