The European Commission’s High Level Expert Group on Sustainable Finance’s interim report reads like a crash course in the financial ecosystem: a pitstop tour of different market players, tools and asset classes, and how they are implicated in the fight for a more sustainable EU financial market. But, given the initial focus on climate finance, there are some notable absences too.
“I searched the interim report for the word ‘tax’, to see how much weight was given to it,” said Jean Boissinot, head of banking and financial sector analysis at the French Ministry of Finance, at the launch of the report in Brussels in July. “There are basically two or three mentions, and it’s not [in relation to] carbon… But then you find 30+ instances of the word taxonomy.”
The interim report does point out that “the absence of a financially material carbon price prevents investors from differentiating carbon-intensive assets from carbon-efficient ones in their economic reasoning”. It also acknowledges that “the need for a strong price signal is not new: in the case of carbon, firms, investors and civil society have been calling for it for years”. And yet it does not take the matter forward in its early recommendations.
This, for some, is the crux of the matter: a group created to focus on regulation and policy has made non-regulatory topics such as the creation of a green classification system a priority, while others that are exclusively policy-driven or regulatory mechanisms – such as carbon pricing – don’t get much of a look in.
And it doesn’t seem to be because the market isn’t interested.
“There are a couple of things missing from the interim report, and one has become a bit of an elephant in the room for these discussions: it’s the economic pricing of carbon,” says Guy Miller, Chief Market Strategist and Head of Macroeconomics at Zurich Insurance Group, adding that “unless a robust stance is taken by credible institutions and working groups, then the pace of change will be too slow”.
“There are a couple of things missing from the report, and one has become a bit of an elephant in the room: the economic pricing of carbon” – Guy Miller, Zurich
“To us, a carbon price is really important, because if you don’t have it priced correctly, then whatever you’re doing on the ESG side will still be insufficient to shift behaviour meaningfully enough to tackle climate change.”
The EU ETS is currently the key mechanism through which Europe explicitly prices carbon, but it has been blighted by problems throughout, leaving the current cost of a tonne of carbon at just €6 – not enough to turn many heads, let alone influence many business decisions. One key factor has been the unexpected slow-down in industrial output, caused by the financial crisis. This means many of the sectors covered, such as utilities, cement and steel, stopped producing emissions as forecasted, leaving them below their limit and prompting a glut in allowances, and little demand. There have been attempts to restore prices by removing some of these allowances (a process known as back loading), but these have just been temporary measures.
“The real game changer will come in 2019, when the Market Stability Reserve comes into play,” explains Tom Lord, a Senior Trader at carbon trading house Redshaw Advisors and former head of Barclays’ emissions trading desk. The MSR is a profound overhaul of the EU ETS in a bid to deal with future supply and demand dynamics.Lord compares it to a central bank, deciding how much currency (or in this case, how many allowances) are put into circulation. The MSR can remove swathes of new allowances from the annual auctions if supply is already above a certain level, and pump more in if it gets below a certain floor. “The MSR is forecast to take prices up into their €20s by the start of Phase Four [the next stage of the EU ETS, which begins in 2021],” says Lord. “So you’re in for some pretty steep and material price rises.”
Lord says that most analysts put a carbon price at between €20 and €30 per tonne before it will start making a real difference, but others want it a lot higher. “We have been thinking along the lines of around $100 [per tonne], based on the work from the World Bank, which shows that a price in the range of between $80 and $120 is required to be consistent with the below 2°C warming goal of COP21,” says Miller.
“The EU ETS is the flagship tool to deal with emissions, and yet it only covers about 45% of EU emissions” – Tom Lord, Redshaw Advisors
And Zurich doesn’t think a carbon market is the only – or even the best – option through which to implement a carbon price. “It would seem best either as a tax or in some form of levy that can be segregated and used with a multiplier effect to help fund renewables or carbon capture technologies,” Miller says, adding that “trading is a good idea in theory, but as we have seen so far, it is difficult to get right and quickly scale up”.
To help the EU ETS gain some of that scale, the system could be widened to include more sectors (transport would be the obvious one, but also agriculture), although there seem to be no plans to do this as part of Phase Four.
“The frustrating thing is that the EU ETS is the flagship tool for the EU to deal with emissions, and yet it only covers about 45% of EU emissions,” says Lord. “There’s no reason it can’t capture more than that.” Beyond the EU ETS, Miller says the level of emissions covered by carbon pricing falls to around 13% globally, agreeing that this must ramp up in order to become “truly meaningful”.
Wilfred Nagel, former Chief Risk Officer at ING Group (until he retired this summer), says political resistance plays a part in the reluctance around carbon pricing in Europe, and financial regulation – such as increasing capital charges for dirty projects – is being pushed by some as a more suitable alternative.
He describes this conversation around capital charges as “barking up the wrong tree”, saying that sustainable finance isn’t currently less risky; and that it isn’t likely to reduce emissions anyway. Based on calculations Nagel did using existing projects financed by ING, he tells RI: “The rough price of electricity generated by a relatively efficient coal plant in Western Europe is about €44 per MwH. If you doubled the capital requirements then, in order to keep returns the same for the investor, you would need to charge not €44, but €44.9 per MwH. That won’t move the needle in any respect.”
He adds: “If you want to get rid of coal, for example, you either tax it, put a carbon price on it, or you simply ban it”. But these are more politically difficult gestures than introducing financial regulation, he says: “It’s my sense that politicians find it a lot easier to do something via the financial sector – which is not particularly popular with anyone at the moment – than to come out and openly attack an industry that employs hundreds of thousands of people. Even if it’s for the survival of the planet. To me, this conversation is all about political convenience.”