Last month an Open Letter to the Bank of England (see below) called for an investigation into "how the UK’s exposure to high carbon investments might pose a systemic risk to our financial system and what the options might be for managing this potential threat to our economic security."

The response came in a few days ago and you can read it in full here (pdf):

Extract

The particular risk you raise is that financial institutions are investing in carbon-intensive firms that may produce lower returns than expected - either through lower dividends on equity or, in extremis, default of corporate debt. The hypothesis is that, if such lower returns were realised, it would have an adverse impact on the financial health of investing institutions, with potentially large consequences for the functioning of the financial system.

To our understanding, such an eventuality would in broad terms require three key ingredients: First that the exposures of financial institutions to carbon-intensive sectors are large relative to overall assets; second that the impact of policy and technology working to reduce returns in high carbon areas is not already being priced into the market, either through lower expected returns or higher risk premia discounting these returns; and third that any subsequent correction would take place over an insufficiently long period of time for the relevant financial institutions to adjust their portfolios in an orderly manner.

The necessity of all three conditions being met raises a question in our minds as to whether or not this is a potential threat to financial stability. Nevertheless, there is clearly scope for further evaluation of these issues, in particular the potential scale of the risk and transmission mechanisms through which it might impact UK financial stability. To this end, we will endeavour to include this in the list of topics we regularly discuss with market participants, to assess whether or not this is a risk of which they arc aware and the extent to which they are taking it into account in their investment decisions.

Ben Caldecott covers the response in The Guardian:

The depth of the financial system's exposure to high carbon and environmentally unsustainable investments could be a systemic risk that threatens economic security. In a letter sent to Sir Mervyn King, the governor of the Bank of England, a coalition of investors, politicians, and academics recently urged the bank to investigate these issues in order to prevent the profound harm that could be wrought by an over-exposure to high carbon assets and a rapid shift in their values.

In an important reply, the governor has now accepted that there is a need for further evaluation and it is encouraging to see the bank willing to consider the levels of fossil fuel exposure as a potential risk to financial stability. We believe this process will serve as an important test of whether anything has been learned from the sub-prime crisis.

The Bank of England has set out its criteria for what constitutes a threat to financial stability. First it questioned whether "the exposures of financial institutions to carbon-intensive sectors are large relative to overall assets"...

...Secondly, the bank asked whether "the impact of policy and technology working to reduce returns in high-carbon areas is not already being priced into the market". The response from the vast majority of conventional energy analysts to the idea of climate risk has been largely negative, with one recently saying publicly: " I think it's a bollocks subject. I'm not interested in this kind of subject. I think this is complete hot air."...

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Environment Economics Research at MoneyScience

OPEN LETTER TO THE BANK OF ENGLAND

Sir Mervyn King
Chairman, Financial Policy Committee
Bank of England
Threadneedle Street
London EC2R 8AH
United Kingdom

 

Dear Sir Mervyn King,

The Financial Policy Committee (FPC), which you chair, was recently created to, “contribute to the Bank’s financial stability objective by identifying, monitoring, and taking action to remove or reduce systemic risks with a view to protecting and enhancing the resilience of the UK financial system.”

As the FPC develops its forward work programme, we urge it to investigate how the UK’s exposure to high carbon investments might pose a systemic risk to our financial system and what the options might be for managing this potential threat to our economic security.

The depth and breadth of our collective financial exposure to high carbon, extractive and environmentally unsustainable investments could become a major problem as we transition to a low carbon economy. Five of the top ten FTSE 100 companies are almost exclusively high carbon and alone account for 25% of the index’s entire market capitalization (1). This exposure is likely to be replicated in other indices, by companies, in bank loan books and in the strategic asset allocation decisions taken by institutional investors. At present regulators are not monitoring the concentration of high carbon investments in the financial system and have no view on what level would be too high.

As policy and technology work consistently over time to reduce returns in high carbon areas while supporting low carbon ones, investing in high carbon sectors, say as an institutional investor looking to generate good returns over a 20 to 30 year period to successfully cover future pension liabilities, could result in stranded assets and poor returns. Counter intuitively, institutional investors, as well as banks, companies, mutual funds and retail investors, continue to risk exactly that by deploying significant amounts of capital into high carbon sectors, or in companies with significant exposure to them. This contradiction was observed in recent Financial Times and Guardian opinion pieces, one of which was written by the leading economist Lord Stern (2). This could be another example of our capital markets fundamentally mispricing assets and, as a result, building up a systemic risk that threatens long term growth.

For many investors an exposure to high carbon and environmentally unsustainable assets is not an active or an informed decision. Instead it is frequently driven by the fact that a large proportion of capital must flow into funds that aim to track the main indices. Many investors have little choice but to do this due to liquidity requirements and the desire to track average market performance. Moreover, new regulatory requirements, such as Basel III and Solvency II, can make it more difficult for investors to deploy capital into longer term assets, such as low carbon infrastructure, and simpler to invest in the status quo, even though there might be significant appetite to do the opposite. In such situations we believe that regulators have a role to play in protecting investors from systemic risk.

To understand the extent of the potential problem we need to assess global, and particularly UK and European, financial exposure to high carbon, extractive and environmentally unsustainable investments. While the exposure of listed companies is beginning to be understood (3), that of non-listed companies, bank loan books and institutional investor portfolios is significantly less appreciated.

We then need to look at how exposure and relative values, between high carbon and low carbon investments, could change over time and how this might affect different parts of the financial system and the system as a whole. For example, how might a sudden change in relative values be different from a longer period of transition? The purpose of this work should be to evaluate the health, soundness and vulnerabilities of the financial system as we proceed with a low carbon transition.

After these studies are completed, we need to develop a strategy that could manage the challenges that might arise as a result of an over-exposure. If this is indeed akin to a systemic risk in our financial system, what macroprudential instruments might be designed and deployed to help to restrain the build-up of risk? Could we change the risk-weightings used to calculate capital requirements? Could we use different discount factors for high carbon investments? What steps can be taken in each part of the financial system? What is the role of regulators – nationally and internationally? What might we do to create sustainable, low carbon alternatives for investors with the right risk-reward profiles? And how could we predict and manage the risks associated with sudden changes in exposures and relative values?

Given its significance over the long term, we hope that the FPC can incorporate this work into its forward programme, with the appropriate expertise and personnel. There are also a variety of organisations, such as the Carbon Tracker Initiative, Oxford University’s Smith School of Enterprise and the Environment, Climate Change Capital, the London School of Economics and Anglia Ruskin University’s Global Sustainability Institute, that are working in this area and they would be able to develop collaborative partnerships with the FPC to help enhance resilient low-carbon economic development, as well as reduce systemic risk in the UK financial system.

We look forward to hearing from you and the Committee in due course.

Yours sincerely,

Paul Abberley Chief Executive Aviva Investors London and Global Investment Solutions Peter Ainsworth Chairman, Conservative Environment Network Ben Caldecott Head of Policy, Advisory Climate Change Capital Catherine Cameron Director Agulhas: Applied Knowledge James Cameron Founder and Vice-Chairman Climate Change Capital Paul Ekins Professor of Energy and Environment Policy UCL Energy Institute, University College London Zac Goldsmith MP Member of Parliament for Richmond Park & North Kingston

The Rt Hon. John Gummer, Lord Deben Former Secretary of State for the Environment Catherine Howarth Chief Executive FairPensions Dr Aled Jones Director, Global Sustainability Institute Anglia Ruskin University Mark Kenber Chief Executive The Climate Group Sir David King Director, Smith School of Enterprise and the Environment University of Oxford Jeremy Leggett Chairman Solar Century and Carbon Tracker Initiative Nick Mabey Chief Executive E3G

David Nussbaum Chief Executive WWF-UK John Sauven Executive Director Greenpeace UK Penny Shepherd Chief Executive UK Sustainable Investment and Finance Association Paul Simpson Chief Executive Officer Carbon Disclosure Project Matthew Spencer Director Green Alliance Dimitri Zenghelis Senior Fellow, Grantham Research Institute London School of Economics & Political Science

1 FTSE 100, 11th July 2011.
2 Caldecott, B.L. (2011) Why high carbon investment could be the next sub-prime crisis. The Guardian, 12th July 2011. See: http://www.guardian.co.uk/environment/2011/jul/12/high-carbon-investment; Stern, N. (2011) A profound contradiction at the heart of climate change policy. The Financial Times, 8th December 2011. See: http://www.ft.com/cms/s/0/52f2709c-20f0-11e1-8a43-00144feabdc0.html#ixzz1g1WNryuV.
3 See: Carbon Tracker Initiative (www.carbontracker.org); Carbon Disclosure Project (www.cdproject.net)

Copy List:
Rt Hon. George Osborne MP, Chancellor of the Exchequer
Rt Hon. William Hague MP, First Secretary of State, Secretary of State for Foreign and Commonwealth Affairs
Rt Hon. Vince Cable, Secretary of State for Innovation, Business and Skills
Rt Hon. Chris Huhne MP, Secretary of State of Energy and Climate Change
Rt Hon. Caroline Spelman, Secretary of State for Environment, Food and Rural Affairs
Lord Turner, Chairman
Financial Services Authority
Hector Sants, Chief Executive
Financial Services Authority
David Kennedy, Chief Executive
Committee on Climate Change
Xavier Rolet, Chief Executive
London Stock Exchange