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Op-Ed I Financial regulation and “green recovery”

4 June 2020 - Op-ed - By : Michel CARDONA

The pandemic caused by Covid 19 has triggered a major economic crisis. The emergency treatment of this crisis relied heavily on massive recourse to fiscal and monetary instruments already widely used during the 2008 crisis. But financial regulation was also mobilized to ease or alleviate prudential constraints in order to preserve bank financing for economic players, especially those most affected by the crisis. For Michel Cardona from I4CE this illustrates the different facets of the use of financial regulation: primarily intended to ensure the efficient functioning of financial markets and financial stability, it can also be used with economic policy objectives. 


The priority in the economic field is now to organise a recovery of activities. And many voices are calling for this recovery to be a “green recovery” to ensure that the “after world” takes full account of the demands of the fight against climate change, demands that did not disappear with the pandemic.



Financial regulation has a role to play in the “green recovery”

The aim of this initiative is to accelerate the financing of the transition to a low-carbon and resilient economy, which will require considerable funding to be mobilised between now and 2050 in order to achieve carbon neutrality. For France alone, there is a shortfall of between 15 and 18 billion euros of investment per year between now and 2023 to meet the trajectory of the National Low Carbon Strategy. The French and European recovery plans will rely heavily on public funding. However, given the scale of the financing needs for the transition, it is essential to supplement public financing with the mobilisation of private funding.


However, it is clear that private finance is not yet there. For several decades, initiatives from private actors, sometimes with the support of public actors, have been striving to bring about the emergence of “green finance” and, more broadly, “sustainable finance”. These initiatives have led to the emergence and rapid development, particularly since 2015 and the Paris Agreement, of financing for low-carbon transition (e.g. Green Bonds) and coalitions of international investors. Despite undeniable successes, this development has fallen far short of what is needed to meet the challenge of climate change. It is therefore necessary to accelerate this transformation of finance to ensure that its action is commensurate with the stakes. In other words, we must move from the objective of developing “green finance” – a simple “niche” market – to the objective of mobilising finance in its entirety towards transition. But it also means that it is the deep mechanisms of finance that must now integrate the requirements of climate change.


At the same time, climate change poses significant risks for financial actors who are struggling to integrate them satisfactorily. These risks are of three kinds: transition risks, linked to the transformation of economic agents towards a low-carbon economy, physical risks, linked to the rising occurrence of extreme and chronic climatic events, and liability risks, linked to possible legal actions. Financial supervisors have taken up this issue, notably through the creation of the NGFS or the IAIS-SIF, on the grounds that these risks are systemic in nature. This insufficient consideration of climate risks by financial actors also has an impact on the financing of the transition since it distorts the assessment of financing’s risks and biases the risk/return ratio which is at the heart of financial actors’ decisions.


In this context, financial regulation has an important role to play in supporting the “green recovery”. At the very least, it must ensure – as part of its two traditional functions – the proper functioning of financial markets (by overcoming “market failures”, particularly in terms of information) and by leading financial players to take climate risks into account. But it is also questionable whether financial regulation should not have a more proactive and incentive action to facilitate and accelerate the financing of the transition to a low-carbon and resilient economy.



Many instruments are available to fulfil this role

Financial regulators and supervisors have different instruments at their disposal to achieve these different objectives. These instruments can be grouped into 6 main families:


  • Increase financial actors’ awareness of climate risks, advancing common knowledge of these risks and encouraging their consideration (via recommendations);
  • Improving the transparency and information of financial markets on climate change with precise and mandatory disclosure rules;
  • Integrate climate criteria into the fiduciary responsibility of asset managers;
  • Strengthen the financial soundness of financial actors by imposing management standards (such as capital requirements or rules on risk division) and by integrating climate considerations into the supervisory process (notably through climate stress tests);
  • Safeguard the stability of the financial sector by developing monitoring instruments (climate-related macro-stress tests) and by using macro-prudential instruments (counter-cyclical capital buffer or sectoral exposure limits);
  • Divert financing flows from sectors unfavourable to transition to sectors critical to transition.


These instruments are different in nature and can be used more or less rapidly. They may fall under supervisory practice, “soft” regulation or “hard” regulation, which means that some can be used within the framework of current regulatory standards while others require changes to those rules. Some instruments can be used at the national level while others require supranational coordination or even international agreement (e.g. to modify certain prudential rules).


On the other hand, some instruments can be used without delay while others still require technical work to be fully operational (e.g. climate stress tests which are still at the “pilot” stage with some leading supervisors).


The intersection of these different characteristics outlines a calendar of actions that can be taken in the short term, or still require ongoing technical developments, or call for a legislative response at the European level (e.g. mandatory and consistent climate reporting; integration of climate criteria into fiduciary responsibility), or require international cooperation that necessarily takes longer (e.g. to modify prudential capital requirements).



A series of actions must be undertaken without delay to accompany the “green recovery”

Actions must be taken immediately by supervisors. It is true that some of them, particularly in Europe, have already undertaken a real effort, but it must be generalised and deepened (for example by formalising precise recommendations for financial players). Furthermore, the technical and methodological work already underway (on the methodology of stress tests or the assessment of climate risks for example) must be continued as it is crucial.


At the same time, the use of the macro-prudential instruments available in the regulations to protect the financial system from the occurrence of systemic climate risk, particularly in the event of a disorderly transition, must be considered, particularly by supervisors but also more broadly. If the instruments exist, their “doctrine of use” in the face of climate risks still needs to be further developed: in particular, how should the instruments be calibrated and what timetable for implementation be effective in a timely manner? If the Covid 19 crisis taught us anything, it is that we must anticipate crises in order to avoid suffering them.


Moreover, international cooperation must be deepened to integrate climate risks into “hard” prudential standards (capital requirements, liquidity or transformation rules, rules on risk concentration).


Finally, the debate must be opened on the advisability of using certain provisions of financial regulations in developed countries to voluntarily direct financing flows to certain economic sectors. This is a controversial issue that gives rise to strong positions. But the urgency and the scale of the climate risk make this debate indispensable to inform political decision-making.


 Network of Central Banks and Supervisors for Greening the Financial System and International Association of Insurance Supervisors- Sustainable Insurance Forum

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