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Did they pick the wrong colour?
Late last year, European lawmakers reached agreement on a “green taxonomy”: a European Union-wide classification system for sustainable activities. The taxonomy creates a “common language” for identifying assets that have a positive impact on the environment and climate, with the hope being that this will increase funding for sustainable businesses and combat “greenwashing”.
Even before the ink was dry on the agreement, however, plenty of stakeholders said the EU had got the whole thing the wrong way around. Instead of starting out trying to make a “green list”, policymakers should have focused on a “brown list” — activities that contribute to runaway climate change and environmental degradation.
Why? Because investors respond to risk/reward signals, and the sustainable taxonomy ignores these. Sure, it identifies business activities by their potential to lower greenhouse gas emissions and contribute to a net-zero carbon future. But its appeal is to investors’ and financial innovators’ sense of ethics rather than their self-interest.
A brown taxonomy, on the other hand, would classify activities by their (lack of) resilience to a low-carbon economy. This makes it a risk-centric classification system — different in kind from the sustainable taxonomy, but one more in tune with how investors think.
Investments in “brown list” activities would be expected to lose value over time, as the assets underpinning their returns became “stranded” due to the world’s transition to net-zero emissions. Think of an oil producer sitting atop a lake of hydrocarbons that can no longer fetch a price because the market for fossil fuels has collapsed.
Fifty shades of brown
Today, there is no agreed-upon means of identifying brown assets or differentiating between them. Climate-conscious market participants recognise that brown assets are out there, and freighted with transition risks that are not yet captured in orthodox financial assessments, but have no means of systematically labelling and comparing them.
Yes, there are indications that investors are differentiating brown assets already, in the absence of any uniform framework. Index and data vendor MSCI shows that brown equities have generally underperformed green equities year-to-date, with oil-linked companies faring the worst, while a survey of corporate treasurers by the Climate Bonds Initiative shows that vanilla bonds attracted lower investor demand than green ones.
But a systemic shift in investor attitudes will be tough to achieve without a clear, credible system for identifying brown assets and weighing their exposure to transition risks.
Some aren’t waiting around for regulators to get their act together. Researchers working with Imperial College London are already working to classify brown risks as a first step towards a functional taxonomy.
Identifying the myriad risk factors that weigh on brown industries is no mean feat. Yes, there are some obvious threats: like the removal of public subsidies for fossil fuel producers and the imposition of carbon taxes. These will have direct, easy-to-quantify impacts on firms’ incomes.
But others are amorphous and hard to pin down. Take resiliency. Certain brown businesses may be able to withstand a low-carbon transition better than others — for example, a power plant with access to carbon capture and storage capabilities could continue burning fossil fuels even within the confines of a net-zero carbon economy.
Others may be able to diversify their business models over time, lessening their exposure to transition risk. Think of those energy companies already shifting out of fossil fuels and into renewables.
The extent to which these offsets can be quantified and set against other brown risks is tricky, though, and can vary depending on the transition pathway taken by a firm’s host government or, indeed, its own board of directors.
They’re also subject to accounting trickery, model risk, and obfuscation. For example, an airline may disclose emissions “savings” based on the projected take-up of cleaner-burning fuels. But what if the price of producing such fuels spirals higher than modelled estimates? Then these savings may never materialise, as the carrier proves unwilling or unable to swallow the higher costs.
That’s why the next challenge facing the Imperial College project is drafting weighting methodologies for each identified brown risk category, and modelling these across various climate scenarios. Then it’ll be possible to shift from a purely qualitative assessment of brown risks to a quantitative one.
The end goal should be an estimate of a firm’s total “brown costs” — the impairment to future cashflows likely because of climate-related transition risks. These can then be used to recalculate default probabilities, which are essential to computing credit ratings as well as equity returns.
Financial institutions could then integrate these brown costs into their risk management analyses and make informed decisions on asset allocation accordingly.
Fitch Ratings says a brown taxonomy could fundamentally change investor behaviour, by influencing ESG-integrated investment frameworks and negative screening processes. Investments in the brown taxonomy could be blacklisted by certain market participants, shutting off a big (and growing) segment of the market to climate-harming firms. Prudential regulators alert to climate risks could also assign higher capital requirements to brown assets held by banks, insurers and asset managers.
Both sets of actions would make financing brown activities more expensive as borrowers would have to pay more to attract investors, pumping up their cost of capital relative to green or climate-neutral alternatives.
This may prompt “brown flight” — a sudden stampede out of environmentally damaging assets that would hammer prices, trigger fire-sales and transmit market risk throughout the financial system.
That would be an extreme response, however. What’s more likely — and sensible — is that investors would use a brown taxonomy as a launchpad for deeper engagements with debtors and securities issuers to get them on a climate-friendly pathway.
Jerome Courcier, sustainable finance expert and former CSR officer at French bank Crédit Agricole SA, puts it best:
“Eradicating ‘evil’ is rational, but not reasonable, since sinners must be given time to convert.”
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