Why climate disclosures alone will not move markets
Transparency on climate risks is important, but it will not divert capital away from fossil fuels without big structural changes to the financial system
Mark Carney’s eye-popping promise last week that up to $130tn of private capital would be committed to net zero has been widely questioned. But his other big finance announcement at the UN climate summit – such as new requirements for the biggest UK firms to make and disclose transition plans – received less scrutiny. It came days after the UK government announced that climate financial disclosures would become mandatory.
It’s the latest in a stream of regulators and central banks – from China to the US – introducing similar regimes as governments pin their hopes on the power of disclosure to direct capital towards low-carbon assets.
The idea behind it is simple: more transparency on climate risks and the fear of stranded assets should push investors away from dirty assets and increase appetite for green investment. But in practice, transparency relies on a pair of untested assumptions that raise serious questions about its ability to shift capital.
Fundamentals dictate investor behaviour
The first is that transparency on climate risk will be enough to motivate investors to move away from carbon intensive assets to reduce risk – in other words, the idea that sunlight is the best disinfectant.
But the world’s most valuable commodity, oil, highlights the holes in that idea. The US and Europe’s decline in fossil fuel sector valuations relative to the broader market began well before financial regulators started to consider climate-related risk disclosure in 2015. It wasn’t climate risk reporting that moved investors - it was OPEC’s decisions that made oil a weaker investment.
Equity returns from fossil fuels are less attractive now than they have been in the past, following years of decline. That simple reality plays a weightier role in investor decisions: it’s no wonder that a survey of institutional investors found they ranked climate risks far lower than other investment risks.
The second assumption worth unpicking is that more transparency will lead to investors ‘switching’ from dirty to clean assets. It sounds sensible, but in reality, there is no single ‘energy investment system’ where capital easily moves from one technology towards the other.
Instead, these are two diverse asset classes that markets treat differently. On one hand, fossil fuels represent a highly consolidated industry, dominated by multinationals and large state actors. On the other, the renewable industry remains a young and fragmented sector missing its “majors”. Despite its rapid growth, it’s still characterised by many small participants, often operating in only one market.
That results in lower revenues and market capitalisation, limiting renewables’ ability to attract investment. For the last few decades, fossil fuel assets have attracted large, stable investments from institutional and investment funds. In contrast, renewable energy assets often still fail to meet investors’ liquidity criteria because of their small size and daily traded volume.
That means these assets aren’t easily switched, no matter how much climate risk is disclosed, because they have their own unique characteristics and risk factors. No investor will sell a fossil asset and replace it directly with a renewable one.
Policy cannot shirk responsibility
Understanding what transparency can’t do tells us what else regulators should be considering instead. Structural changes to the financial system, like innovation in low-carbon financing, are more likely to increase climate finance flows.
First, the financial ecosystem needs to expand to bring low-carbon investing into the mainstream, making it more attractive to investors. This means scaling up existing green financing channels like green bonds and ETFs, and further securitisation of alternative energy assets that appeal to broader financial market participants. Climate and energy policies need to play their part by incorporating financing considerations – like investor preferences, risk appetites and capital base – into policy design to create a stronger ecosystem for green assets.
Second, green policies need to be better integrated into monetary, fiscal and macro-prudential policy. Introducing climate considerations into monetary policy would directly impact central banks’ asset purchases – especially relevant considering that most central banks’ corporate asset purchases remain biased towards high-carbon industries.
Third, international climate policy should prioritise capital flows in developing countries. This is a critical challenge facing international climate cooperation given the difficulties that these countries have in accessing capital at favourable terms. International action needs to create financing channels to attract diverse private capital, reduce costs and create sustainable international financial structures.
Mark Carney isn’t alone in expecting disclosures to move investors away from carbon-intensive assets. But the idea that they can effectively shift capital has serious flaws, and this means they can only be one plank of a strategy to finance the transition to net zero. If central banks and regulators continue to line up behind transparency initiatives, they’re at risk of giving the finance sector a permission slip to skip more effective action.
Nadia Ameli is principal research fellow at University College London's Institute for Sustainable Resources, Michael Grubb is its deputy director and professor of energy and climate change, and Sumit Kothari is a PhD student at UCL’s Bartlett School of Environment, Energy and Resources.