Why policymakers struggle to mitigate net zero transition risks
Part V of NZI’s Putting a Price on Pollution series explores the dangers of a disorderly transition
Central bankers and risk experts have long stressed the dangers of a disorderly transition to a net zero economy.
Take the Financial Stability Board’s (FSB) too-little-too-late scenario for example, the “materialisation of physical risks could prompt more significant policy action to stem them”, resulting in a disorderly transition.
On the other hand, the financial stability risk of “a well-anticipated transition” to a low carbon economy are relatively contained, albeit with various “measurement uncertainties”.
Climate aside, the World Economic Forum (WEF) estimates that half of the world’s GDP is moderately or highly dependent on nature, meaning ecosystem collapse would also precipitate financial collapse.
Yet despite such clarity, and the obvious need to avoid a disorderly transition, the WEF marks “failure to mitigate climate change”, “failure of climate-change adaption”, “natural disasters and extreme weather events,” and “biodiversity loss and ecosystem collapse” as the top four risks for the next 10 years.
Cognitive dissonance on a global scale
While there may be political leadership at international as well as awareness-raising level, sources suggest that governments struggle to overcome the “short-termism” that makes them prefer short-term gain at the price of long-term pain.
“It seems most major governments are waiting for a full-blown crisis before they embark on radical change,” said Colin Lawrence, former Bank of England regulator and non-executive director and chair, risk, compliance & audit at OSTC.
“Once a crisis hits, there will be politicians who benefit from fixing it and politicians who will be voted out of office for not doing enough. The sad thing is it won’t come as a surprise."
That is because "politicians and citizens alike tend to be more concerned about day-to-day living than the bigger picture. It’s cognitive dissonance on a global scale.”
With the “green arms race” in full swing following the publication of the US’s Inflation Reduction Act and the EU’s Net Zero Industry Act, Lawrence argued that the political narrative is “too focused” on the positive story of a green economy.
Although the green transition might deliver a slight net-win or net-loss, the point of the sustainable economy isn’t to deliver growth and new jobs but to avert catastrophe.
Indeed, the narrow focus on growth for individual jurisdictions can sometimes feel like a false lens through which to view a global problem.
Even the green jobs narrative is at least slightly disingenuous, as the success of the new green industry depends, in the long run, on the demise of the old pollutant industry and all the disruption and dislocation that such a loss entails. While some industries may be able to transition, others will have to be shut down.
“The core of our economies are pollutant and extractive,” said Carlijn Kamp, program officer for the chief economist at Triodos Bank.
“And because it’s so big and so entwined, the transition can’t happen overnight, but requires careful planning. Unfortunately, societies, as a whole, seem more concerned about today than the future."
Kamp stressed: "The more we wait, the greater the risk of a disorderly transition.”
Risk in diverse places
The Task Force on Climate-Related Financial Disclosures (TCFD) groups transition risks into four categories. “Policy and Legal Risk” consists of carbon pricing and reporting obligations, mandates on and regulation of existing products and services and exposure to litigation.
Technology risk includes the substitution of existing products and services with lower emissions options the unsuccessful investment in new technologies.
Market Risk entails changing consumer behaviour, uncertainty through market signals, and increase cost of raw materials.
Reputation Risk is composed of shifts in consumer preferences, increased stakeholder concern/negative feedback, and stigmatization of sector
The overall impact of such risks is that that some sectors of the economy could face big shifts in asset values or higher costs of doing business, according to the Bank of England.
The TCFD believes that companies that tackle transition risk as part of a broader ESG initiative “will be better prepared to mitigate these impacts”.
With or without policies that price in the negative externality of pollution into the global economy, various financial firms have already begun to heed the TCFD’s advice and integrate transition risks into their ESG strategy.
“We are measuring transition risk as much as we can,” said Patrick Simion, chief of staff at BNP Paribas Asset Management.
“As an investor, we're taking into account ESG criteria in all our investment strategies, because we think that we can provide more value to our investors by anticipating what will happen in the future."
He added that: "Thanks to the information we have gathered on how companies are transitioning, we have developed a long term strategy and should be relatively protected against transition risk.”
Assigning an ESG score, which includes a transition risk component, to companies in its portfolio enables BNP Paribas Asset Management to exclude the worst and invest more in those that represent best practice in any given sector.
“We can’t just invest in what’s already green, we also have to transition pollutant industries, given the size of the task at hand,” he added.
The ECB test report is less optimistic about the overall resilience of the EU’s financial sector to transition risk.
The 2022 ECB stress tests showed that, on aggregate, almost two-thirds of banks’ income from non-financial corporate customers stems from greenhouse gas-intensive industries. In many cases, banks’ “financed emissions” come from a small number of large counterparties, which increases their exposure to transition risks.
What if the transition happened tomorrow?
This article opened with the rather pessimistic suggestion that governments are inherently short-termist and won’t accelerate the transition until disaster bites.
But what would happen if a global agreement were reached and transition measures that effectively put a price on pollution were enacted overnight?
First, it is worth remembering the scale of the problem; only a handful of the 43,000 listed companies in the world don’t have a net negative impact on climate and biodiversity, according to ASN Impact Investors. That means anyone who owns stocks and shares is inadvertently supporting pollution.
According to the Bank of England, if government policies worldwide changed in line with the Paris Agreement, two-thirds of the world's known fossil fuel reserves couldn't be burned.
As well as affecting energy companies, this might change the value of investments held by banks, insurers or pension funds in coal, oil or gas companies.
“The idea that the green transition is a win-win scenario is mythical,” said Simon Zadek, executive director at Nature Finance. “One clear example of the potential fallout is in the food system.”
The World Bank estimates that the $8 trillion world food systems owes $12 trillion a year in hidden social, economic, and environmental costs. That means if the food system was a single company in a true cost economy that factored in the negative externalities of pollution, it would be insolvent.
A joint report from Nature Finance and McKinsey concluded that if the green transition happened overnight, there would be significant negative impacts on employment and significant rises in the cost of nutrition.
“A key challenge for the agriculture sector is to feed an increasing global population, while at the same time reducing the environmental impact and preserving natural resources for future generations,” the OECD noted.
As Part IV of this series suggested, the solution to the multi-faceted “transition risk” problem is co-ordinated policymaking.
To mitigate the transition risk and the associated political risk, putting a price on pollution should be accompanied by a range of policies that include green subsidies, support for workers in affected sectors, and investments in different kinds of green technologies and business developments
The ideological barrier
While the case to accelerate the green transition is clear, Jakob Thomä, co-founder and principal at 2 Degrees Investing, said policymakers and central bankers, who may be committed at a personal level, are often held back by an ideological barrier and an imaginary lobby.
The ideological barrier consists of the idea that “financial policy design should be economy neutral”, and that the central bankers don’t have a clear enough mandate to interfere in the economy by introducing, say, green subsidies or brown penalising factors, such as extra capital charges for pollutant assets.
Sources also noted that proponents of “market-based solutions” are reluctant to accept a greater role for government interventions, even at a time when it seems clear that such interventions are required because of the increased risk of market failures.
The imaginary lobby
Meanwhile, the fear of a public and industry backlash over say, implementing disclosure rules and clear transition pathways for pollutant sectors is usually overstated, according to Thomä.
“The EU took years to follow up on France’s article 173, which was passed in 2015,” he said. “Although industry groups have sought to water it down and influence policy design, there was very little actual political capital expended on introducing a mandatory disclosure regime.”
Another example of the imaginary lobby is the EU’s decision to ban the sale of petrol and diesel cars from 2035.
This seismic economic intervention – the only clear transition pathway to be implemented to date – received little to no protest by the general public. It has also given car manufacturers a clear date and target, and, more importantly, a limitation to spur on innovation.
That said, there is also a question mark around whether "the transition to electric vehicles" would have happened anyway by 2035, according to Thomä.
In other words, the one radical measure that policymakers have adopted may not be as ambitious as it seems.
“Politicians are often afraid of the very short-term consequences,” Ugo Biggeri, president of Eticasgr, an Italy-based, sustainability-focused investment fund.
“We’ve already reached the 27th COP and emissions continue to rise year-on-year. Unfortunately, it looks like we need a catastrophe to manage the long term problems of climate change and biodiversity loss and initiate a true paradigm shift. But, of course, the longer we leave it, the greater the problem becomes. And by then it may be too late.”