Accuracy Talks Straight #1 – The Academic insight

Consequences of the development of green finance for companies | 8-minute read

Franck Bancel
Academic adviser, Accuracy

Since the Paris Agreement was signed in 2015, the fight against global warming has established itself at the top of the agenda for many companies. The reduction of greenhouse gas emissions has become a priority, requiring the implementation of new management systems. In this context, so-called green finance, which enables environmentally friendly project financing, is gaining traction. The development of green finance has major consequences for companies and raises multiple questions: how can we define the concept of green finance? What does it mean for companies? What is the role of the financial sector? What financial instruments have been specifically developed to meet company needs?

What is green finance?

Green finance groups all financial activities that contribute to the fight against global warming. For this reason, it is also called ‘climate finance’ or ‘carbon finance’. It is not ‘sustainable finance’. Sustainable finance, which has a broader definition, prioritises responsible investment (RI) and adds environmental, social and governance (ESG) criteria to purely financial criteria.

Green finance calls into question one of the major principles followed by financial analysts. Traditionally, finance has no other objective than to facilitate the allocation of resources to the most profitable projects, without consideration of their impacts on the environment. By contrast, for green finance, only the projects that favour the transition from fossil fuels should be considered. This does not mean that the notion of profitability ceases to exist; nothing prevents companies from choosing the most profitable projects from amongst the green projects available; what changes is the order of priority. The search for profitability is now subordinate to the green nature of the investment.

What is climate risk for companies?

As Mark Carney explained in his famous speech from 2015 on ‘Breaking the Tragedy of the Horizon’, climate risk can be broken down into three distinct risks. First, the occurrence of extreme climate- and weather-related events (hurricanes, droughts, etc.) may generate a physical risk that materialises through the destruction of certain assets and losses of activities for companies. Transition risk is linked to regulatory changes decided upon by public authorities, which may lead certain companies to call into question their economic model or even to disappear altogether. Let us take the example of the automotive sector: because of regulatory changes, the manufacture of combustion engines (petrol or diesel) will diminish drastically in the decade to come, even though these engines utterly dominated just a few years ago. Finally, liability risk related to non-compliance with environmental legislation may generate significant financial damage and interest. We can imagine that in the more or less distant future, companies may be pursued legally for endangerment of others, as were, for example, tobacco companies.

At first glance, one might consider that the majority of these risks will not materialise in the short term and that companies have the time to adapt. We think, on the contrary, that companies must anticipate these risks and quickly implement the appropriate management processes to deal with them. Certain sectors must adapt now: their longevity is threatened. In this way, in the oil and gas sector, certain major players have started to invest massively in new sectors (batteries, electricity, etc.) and to diversify their operations significantly. As for the less polluting sectors, the need to reform may be less urgent, but the trend remains the same. Large groups will gradually force their subcontractors to reduce their carbon footprint and pressure will be high on SMEs. Access to financing in good conditions will also require compliance with emission criteria (and more generally with ESG criteria). This is what banks explain, as their credit distribution models develop in this sense. The image and value of a company’s brand is now inherently linked to its ability to contribute to the fight against global warming.

How can companies manage climate risk?

Climate risk is not the subject of a centralised management process in the majority of companies. Today, two large departments are involved in the management of climate issues: the sustainable development department ensures the operational management of projects compatible with the fight against global warming. This means enabling the company to comply with its climate commitments by proposing operational solutions to reduce its carbon footprint throughout the value chain. For example, can the company replace one material with another whose production emits fewer greenhouse gases, without altering the quality of the final products? How can the more virtuous suppliers in terms of emissions, etc. be selected? The finance department centralises the information and produces financial and extra-financial reporting in relation to environmental performance. Climate reporting will become a central part of a company’s financial communications in a context where financial information will become standardised under pressure from the financial community and public authorities. Investors request more and more information to evaluate not only emissions but also all negative externalities. In the years to come, the sustainable development and finance departments will have to cooperate further and produce together new indicators that incorporate both financial and environmental performance.

Moreover, the companies in certain sectors (power plants, manufacturing plants, etc.) are subject to emission ceilings. They are granted a certain quantity of emission rights (quotas) but can purchase further rights on the market if they find that they do not have enough (or indeed they can sell their rights if they find themselves with an excess). The European Union has committed to a policy to reduce the number of quotas available, which should automatically generate an increase in their value over time and result in new constraints for companies. 

What is the role of the financial sector?

For the financial sector, the aim is to redirect activity as a priority towards projects compatible with the fight against climate change. Most of the large players in finance, whether banks or investment funds, have made commitments to reduce the carbon footprint of their portfolios. As a result, some banks have stopped financing companies that operate in the coal sector. More generally, one may question the financing of ‘fossil fuel’ companies; the continuation of their activities would challenge the objectives set to limit global warming (certain writers talk about ‘stranded assets’ to discuss these fossil fuel assets). Banks are now obliged to undertake climate stress tests and measure the impact of climate risk on their solvency. Article 173 (paragraph VI) of the Loi sur la Transition Energétique pour la Croissance Verte (Law on Energy Transition for Green Growth) requires portfolio management companies to publish information on the consideration of their ESG policy and therefore on the consequences of their investments on the climate.

To help investors better grasp this new environment, public authorities have implemented ecolabels in various countries that require labelled funds to invest significantly in green assets. This is the case in France with Greenfin, in Luxembourg with LuxFLAG Environment and LuxFLAG Climate Finance, and in Nordic countries with Nordic Swan Ecolabel. These labels are backed by a taxonomy that defines what a green economic activity is. The taxonomies play a major role in this respect because they guide investors in their investment decisions. The European Union has created a draft taxonomy that distinguishes between carbon-neutral activities (low-carbon transport, etc.), transitioning activities (building renovation, etc.) and transition-facilitating activities (production of wind turbines, etc.).

What are green financial instruments?

In this context, new financial instruments have been developed by markets and banks with the aim of promoting the transition to greener energy sources. For example, green bonds have experienced spectacular growth in the past few years. They are bonds from which the funds collected must exclusively be used to finance or refinance, in whole or in part, green projects. For a company, issuing green bonds generates significant additional costs (administrative costs linked to the issue process, legal costs, audit costs, reporting costs, higher mobilisation of staff, etc.) for a very limited reduction in the cost of financing. According to financial literature, the additional costs equate to seven base points, whilst the premium is only two points. However, issuing green bonds enables companies to increase their investor base, secure the issue even in difficult market conditions and generate organisational gains (better cooperation between the finance and operational teams, increase in competence of the finance teams on subjects linked to ecological impact, etc.). Green bonds are not the only green financial instruments that have been developed. Banks, for example, have started to securitise green assets (that is, issue securities on the market whose value is based on the repayment of green loans). The development of this market will depend, however, on regulators, which may reduce the capital costs of the banks that finance this type of loan or even make the financing costs of ‘brown’ assets more expensive.

In conclusion, the fight against climate change has created in only a few years a new paradigm. For a company, considering that it need not pay any attention and just continue business as usual seems like a risky choice. However, although the route has been mapped out, a great many questions essential to the deployment of green finance projects and tools remain unanswered. The transition to greener energies is particularly technical; the physical measures, just like the financial ones, are either subject to disagreement or considered insufficient. Convergence is expected to take place in the coming decade and will further accelerate the changes under way.

< Read more from Accuracy Talks Straight