THE TIGHTENING LINKS BETWEEN

FINANCIAL SYSTEMS AND THE

LOW-CARBON TRANSITION
Emanuele Campiglio - Vienna University of Economics and Business
Antoine Godin - Kingston University
Eric Kemp-Benedict - Stockholm Environment Institute
Sini Matikainen - London School of Economics and Political Science

Cambridge March 31st, 2017

Cambridge Trust for New Thinking in Economics
Introduction
The effect of the Global Financial Crisis (GFC) on the prospect
of a low-carbon transition
Focus on GFC-induced policies and their effects on the transition

The immediate effects have been moderately negative:

Decrease in public spending and fiscal support
New macroprudential regulation discouraged bank lending to low-
carbon projects
Monetary policies perpetuated the high-carbon lock-in of the system

However, new space for concept development and policy

proposals:
Green growth and the push for carbon pricing
Climate-aligned macroprudential regulation
Green quantitative easing (green bonds)
The low-carbon transition trade-off

Source: Campiglio et al. (2017)

A slow transition would lead to high climate-induced costs (physical

damages, economic loss, financial instability)
A too rapid transition would lead to high adjustment costs (sectoral
economic losses, financial instability)
Need to find a balance between these two extremes
THE EFFECT OF GFC-INDUCED
POLICIES ON THE TRANSITION
Spending and taxation
Macroprudential regulation
Unconventional monetary policies
Fiscal policy (I)
At first, counter-cyclical
stimulus packages
Green New Deal: use the
occasion to give a boost
to the green economy
But soon after: austerity
Fiscal policy directed
towards achieving
balance budgets
Reduction of public
expenditure

Source: Barbier (2010)

Fiscal policy (II)
In theory, austerity strategies can have a range of different
effects for the transition:
1. Reduction of public spending
Negative: reduction or elimination of sustainable infrastructure
development
2. Reduction of fiscal support
Negative if its subsidies to low-carbon technologies being cut
Positive if its fossil fuel subsidies
3. Increase in the tax burden
Positive if it involves the introduction or expansion of environmental
taxation (e.g. carbon tax)
Fiscal policy (III)
What actually happened?
1. Reduction in public spending and investment
2. Reduction of feed-in tariffs for renewable energy
In some cases retroactively
3. No reduction of fossil fuels subsidies
But main subsidisers only marginally hit by crisis
4. No generalized introduction of environmental taxation
With exceptions: Ireland, Iceland, France and others
 Carbon taxation around the world

Source: PMR 2017

A shifting narrative
More generally, public discourse shifted towards short-
term economic issues
Long-term environmental considerations considered as
postponable luxuries

..the repeal of the carbon

tax means a $550 a year
benefit for the average
family

On energy, I will cancel job-

killing restrictions on the
production of American energy
including shale energy and
Tony Abbott clean coal creating many Donald Trump
Former PM of Australia President of the United States
millions of high-paying jobs
Source: Wikiquote
Macroprudential regulation (I)
Basel III regulation Source: BCBS
 The environmental effects of macropru
Basel III could be negatively affecting bank lending towards low-carbon
sectors
In particular, renewable energy projects

A higher degree of risk is associated with long-maturity project finance,

Risk-weighted capital ratios worsen
But: default rate of rated project finance debt is lower than the one for corporate issuers

Project finance debt not classified as high-quality liquid asset by LCR

Loans to renewable energy have longer tenors compared to gas/coal plants
This is due to high initial capital costs
Banks have to match long-term assets with stable funding for a longer period
This may lead banks to reduce the tenor of the loan (refinancing risk)

In general, Basel III could push lending towards liquid, short-term, risk-free
assets
Renewable projects are illiquid, long-term investments, with a range of attached risks

However, still unclear how relevant this effect is

Banks seem to be coping well with capital and liquidity requirements
Survey by CISL (2014): Basel III requirements a marginal factor in lending decisions
Monetary policy
Cut in interest rates
Expansion of balance sheets (Quantitative Easing)
Mainly sovereign bonds, but also covered bonds, asset-backed
securities, corporate bonds (ECB and BoE), equities (Japan)

Source: BIS 2016

The environmental implications of QE
Some QE programmes started purchasing private securities
European Central Bank: Corporate Sector Purchase Programme (CSPP)
Bank of England: Corporate Bond Purchase Scheme (CBPS)
In principle, purchases aim to be neutral
BoE respects certain sectoral shares of eligible bonds
ECB focus on rating
In practice, they are likely to show an institutional or sectoral bias, although
unintentional
Even using relative market size as benchmark may reflect existing market distortions
More generally, purchases are likely to create a spread in financing conditions between firms

Source: Keohane 2016, FT Alphaville

 ECB CSPP programme
18%

Manufacturing*
16%

14%

12% Real estate activities

Percentage of GVA

Wholesale and retail trade

10%

8%

Transportation and storage

6%
Financial and insurance activities
Information and communication Electricity, gas, steam and air
4% Administrative conditioning supply

Chemicals and chemical products

2%
Refined petroleum and coke
production
0%
0% 5% 10% 15% 20% 25% 30% 35%
Estimated percentage of purchases

Size of bubble indicates relative contribution to emissions in the Eurozone

Source: Campiglio et al. (2017)
Bank of England CBPS programme
16%

14%

Real estate ac7vi7es

12%

Wholesale and retail trade

10%
Percentage of GVA

Manufacturing*

8%
Health and social work
Informa7on and
6% Educa7on communica7on
Electricity, gas, steam and air
Transporta7on and storage condi7oning supply
4%

Mining and quarrying

2%
Water supply
Manufacture of petroleum
0%
0% 5% 10% 15% 20% 25% 30% 35%
Es1mated purchases

Size of bubble indicates relative contribution to emissions in the UK

Source: Campiglio et al. (2017)
NEW CONCEPTS AND
POLICY PROPOSALS
Green growth
Climate-aligned macroprudential regulation
Green quantitative easing
Green growth
At first: Sustainable Development (SD)
But: narrative too focused on sacrifices and costs
Post-GFC: looking for a positive, economy-friendly narrative
Green growth
No need to choose between environmental sustainability and
economic prosperity
Grow through the expansion of green sectors
All major international institutions support it
Green growth (II)
Policy intervention required
Market failures to be corrected
Main tool: carbon pricing
Revenue recycling and the double dividend from carbon taxation
However, is it realistic?
Governments fiscal action paralysed by austerity strategies
Sluggish growth suggests to avoid further taxation
Even in normal times, will the effort ever be strong
enough?
Required decarbonisation rate much higher than ever experienced
(Antal and van Den Bergh, 2015; PwC, 2015)
Additional market failures in credit markets (Campiglio, 2016)
Climate-aligned macropru (I)
Align macroprudential regulation to climate objectives
Climate-related financial risks acknowledged by central banks and
financial regulators
Rationale: climate-related financial risks (Carney 2015):
Physical risks (Dietz et al., 2016)
Liability risks
Transition risks
Transition risks: stranded assets
Fossil fuel reserves
Stocks of high-carbon physical capital
Stranded financial assets and potential cascade effects
Battiston et al. (2016)
Climate-aligned macropru (II)
Differentiated reserve requirements
Decrease reserve requirement ratios for banks that lend to low-
carbon activities (Rozenberg et al. 2013)
The Lebanese experience
However, unlikely to work in high-income countries where central
banks mainly want to fix interbank rate (Campiglio, 2016)
Differentiated capital requirements
Different capital adequacy ratios according to the type of lending
they provide
Green risk weighting for capital requirements
ESG considerations in risk formulation?
Green Quantitative Easing (I)
Central banks are purchasing large amount of assets
Direct the purchase towards low-carbon assets (green bonds)?
Green bonds can be issued by governments, companies and
development banks
Purchase of green bonds issued by development banks
ECB is already purchasing bonds from supranational entities (e.g.
European Investment Bank)
The precedent of Canadas Industrial Development Bank (Ryan-
Collins, 2013)
Development banks bonds tend to have good ratings and are able
to lend at lower cost
Constraints put on development banks
Leverage ratios and conservative capital management
No autonomous balance sheet expansion
Green Quantitative Easing (II)
Reluctance of central banks to target specific sectors
Shape of the economic system responsibility of elected
governments
Too many eggs in their basket

However: many examples of targeted intervention

TLTRO by the ECB (excluded financial sectors and lending for
house purchase)
Funding for Lending Scheme in the UK (SMEs)
Bangladesh and emerging economies (Monnin and Barkawi, 2015)

And even when not explicitly targeted, sectoral effects are

likely (Krishnamurthy, A. and Vissing-Jorgensen, 2011)
CONCLUSIONS
Conclusions
Finance-climate risks increasingly relevant
Need to finance the transition to a low-carbon economy
Climate-related transition financial risks

The effects of the GFC:

1. Moderately negative direct effects
Postponement of public spending and reduction of green fiscal support
GFC-induced financial regulation reduced incentives for low-carbon lending
Unconventional monetary policy perpetuated the high-carbon status-quo

2. Potential positive longer-term effects

New concept development and policy proposals
Green growth as a growth-friendly version of Sustainable Development
Include climate risks into macroprudential regulation
Use expanded powers of central banks to finance sustainable investment
 THANKS!
Emanuele Campiglio
Vienna University of Economics and Business
emanuele.campiglio@wu.ac.at
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