This paper is part of the Fide Foundation’s GET-2 ESG Think-Tank final report from the 2024 Oxford Congress, titled “Driving Change: Exploring Opportunities and Challenges in Accelerating Sustainable Finance.”
Key Findings
Climate change is a fact increasingly evolving, highlighting the urgent need to act on sustainability all the relevant stakeholders needing to take part. On the public side, the Eurosystem has adopted a tilting methodology in its monetary policy portfolio of corporate holdings, favouring issuers with better scores and limiting those with lower scores. This shows a commitment from the Eurosystem in a changing environment due to climate change.
Sustainable development, from a regulatory perspective, is based on transparency to provide relevant information to investors and stakeholders. Although progress has been made in this area, it is crucial to continue improving the use of data before and after investment decisions. Regulatory limitations must be resolved to advance effective implementation. The CSRD, which replaces the NFRD, expands the scope of reporting content and increases the number of affected companies.
Financial institutions struggle to understand their exposure to climate risks and protect their investments, while companies struggle to have a comprehensive view of the geographical distribution of their value chain. Climate risk models, developed by public and private stakeholders, are crucial tools for calculating premiums and identifying hotspots, although they vary in quality and transparency.
Abstract: The European Central Bank (ECB) is incorporating sustainability data into its decisions, aligning with the Paris Agreement. Despite regulations like CSRD and EU Taxonomy promoting transparency, challenges remain in managing data and applying it to investment strategies. Standardized models and databases are needed for effective sustainable transformation.
Keywords: European Central Bank, sustainability data, Eurosystem, corporate bond holdings, Paris Agreement, climate score, tilting methodology, CSRD, EU Taxonomy, SFDR, transparency, backward-looking data, forward-looking metrics, sustainable transformation, European authorities, standardized models, homogeneous databases.
Contents
The global average surface temperature has increased by over 1°C, resulting in 7% more moisture in the atmosphere. Three-quarters of scientists agree that global warming will exceed 2.5°C by 2100, and the probabilities of extreme weather events are increasing. Small rises in average temperatures lead to large increases in the probabilities of extreme weather events.
In 2023, global losses from natural disasters exceeded $250 billion, compared to $100 billion in the 1980s and 1990s. Of these losses, $100 billion were insured and $150 billion were not. Insurance coverage varies significantly by region, with 66% in the US, 50% in Europe, and only 10% in Asia. The World Economic Forum has identified extreme weather as the number one risk for 2024.
Climate risk models combine climate scenarios, location-specific exposure, and vulnerability. There are two types of models: those developed by (re)insurers and those by vendors like MSCI and Moody’s. Models from (re)insurers are very detailed and useful for calculating premiums and identifying hotspots, while vendor models vary in quality and transparency.
However, these models have limitations. Climate models are mainly available for OECD countries and lack transparency and comparability. Many models assess current risks but not future scenarios, and CDP disclosures are company-specific without a reporting standard. The next challenge is to develop models that can assess multiple hazards simultaneously.
In this sense and to effectively address climate change, it is crucial that all involved parties, both public and private, take decisive action. Public investors must lead with policies and funding that promote sustainability, while private investors have the responsibility to direct capital towards clean technologies and responsible business practices. Only through close collaboration and firm commitment from all parties we will be able to mitigate the impacts of climate change and build a more resilient and sustainable future.
Furthermore, all relevant players on the financial markets, from Central Banks to all other institutions, are dealing with the reality of incorporating sustainability data for their decisions. This is not an easy task due to the various challenges faced.
From the public sector, the Eurosystem implemented in 2022 a tilting methodology in its monetary policy corporate bond holdings, which involves calculating a specific climate score for each issuer. This score aims to improve the weighted average climate score of the holdings over time, on a path aligned with the goals of the Paris Agreement. The climate score is derived from publicly available data and metrics as well as other relevant information, including methodologies like the Science-Based Targets initiative and the EU Climate Transition and Paris-aligned Benchmarks.
The climate score consists of three subscores: backward-looking emissions, forward-looking targets, and climate disclosure. Once calculated, the Eurosystem adjusts its benchmark by increasing the weight of higher-scoring issuers and decreasing the weight of lower-scoring ones. This adjustment influences the purchase volumes for each issuer, considering both their climate performance and other risk management factors. These climate scores aim to incentivise issuers to decrease their carbon emissions, to plan and set up their forward-looking decarbonisation targets and calculate and disclose their carbon footprint.
In addition to adjusting the benchmark, the Eurosystem continues to purchase securities from issuers with better climate performance and giving a special treatment to green bonds in the primary market. It also employs measures such as maturity limits for lower-scoring issuers to further mitigate climate-related financial risks. These strategies are part of the Eurosystem’s broader effort to incorporate climate considerations into its strategy.
However, implementing these climate change considerations presents several challenges. Despite these challenges, the Eurosystem is committed to integrating sustainable characteristics into its portfolio strategy to support its climate goals.
In this regard, sustainable development has long emphasized transparency to provide stakeholders with relevant sustainability information. While this goal has largely been achieved, further progress is needed to ensure effective use of data before and after investment decisions. However, various regulatory limitations must be addressed to enhance implementation.
The Corporate Sustainability Reporting Directive (CSRD) aims to expand the scope of the Non-Financial Reporting Directive (NFRD) and increase the number of companies reporting. A key aspect is the double-materiality approach, aligning investors and companies on sustainability impacts, risks and opportunities. Despite this, CSRD struggles with comparability due to some of its current qualitative data. The EU Taxonomy Regulation seeks to define sustainable activities but requires detailed analysis to align investments with technical criteria, and a Social Taxonomy is still missing. The Sustainable Finance Disclosure Regulation (SFDR) aims to reduce information asymmetries but has inconsistencies in reporting requirements. Additionally, the proposed regulation on ESG ratings addresses heterogeneity among providers but does not standardize assessment methodologies.
To achieve global sustainable transformation, it is crucial to generate value from data by translating it into quantifiable financial impacts. This requires homogeneous databases, standard models, and benchmarks from European Authorities to maximize the utility of raw data.
The practical implementation of climate change considerations does not lack of challenges, as previously mentioned. These range from how to get and deal with backward-looking data, how to interpret forward-looking metrics and how to aggregate all these into a portfolio level, ultimately taking investment decision to incorporate sustainable characteristics into a portfolio strategy.
To unlock and achieve a global sustainable transformation, the market needs the Authorities around the world to provide more resources on homogeneous databases, standard and widely used models and benchmarks that serve as a reference to gain value from raw data. Merely strengthening disclosure requirements on climate-related data and ESG information could increase regulatory burdens without having a significant and productive impact. Therefore, regulators should not only mandate by enable the development of new models based on collaborative industrial strategies that facilitate the transition while constraining the old ones. Companies and investors need more incentives to integrate sustainability into their business and investment decisions.
Conclusions
To achieve a sustainable transformation, it is imperative to leverage data effectively by developing homogeneous databases and standardized models. Regulatory frameworks like the Corporate Sustainability Reporting Directive (CSRD) and the EU Taxonomy Regulation need to be improved and further developed. Additionally, the Eurosystem’s tilting methodology and climate scoring initiatives serve as valuable examples of integrating climate considerations into financial decisions. By aligning investment strategies with climate goals and enhancing regulatory measures, we can build a more resilient and sustainable future.
Standardizing climate disclosures and reporting is another key proposal. Implementing uniform reporting standards can ensure consistency and comparability in climate risk assessments, making it easier for stakeholders to make informed decisions. Leveraging data effectively by developing homogeneous databases and standardized models is also vital. This approach can maximize the utility of sustainability data, helping to translate it into quantifiable financial impacts.
Additionally, enhancing insurance coverage in vulnerable regions is crucial. While the US and Europe have relatively higher insurance penetration, Asia lags significantly behind, exposing it to greater financial risks. Increasing insurance coverage in these regions can help mitigate the economic impact of natural disasters. Additionally, improving climate risk models to include future scenarios and multiple hazards is essential for better preparedness and resilience. These models should be transparent, comparable, and applicable globally, not just in OECD countries.
In conclusion, addressing climate change requires a multifaceted approach involving enhanced insurance coverage, improved climate risk models, standardized disclosures, effective data utilization, and refined regulatory frameworks. By implementing these proposals, we can better manage climate risks and work towards a more sustainable and resilient future. Close collaboration and firm commitment from all parties, public and private are essential to mitigate the impacts of climate change and achieve global sustainable transformation.
The current evidence requires urgent climate related actions. With predictions of global warming exceeding 2.5°C by 2100, the frequency of extreme weather events is set to rise, leading to significant economic losses. Collaborative efforts between public and private sectors are essential to mitigate these impacts and build resilience.
To address these challenges, several proposals can be made:
- Enhance Insurance Coverage: Increase insurance penetration in vulnerable regions like Asia to reduce financial risks associated with natural disasters.
- Improve Climate Risk Models: Develop transparent, comparable models that assess future scenarios and multiple hazards, applicable globally.
- Standardize Climate Disclosures: Implement uniform reporting standards to ensure consistency and comparability in climate risk assessments.
- Leverage Data Effectively: Create homogeneous databases and standardized models to maximize the utility of sustainability data.
- Refine Regulatory Frameworks: Strengthen directives like the CSRD and EU Taxonomy Regulation to ensure they effectively guide sustainable investments.
- Adopt Climate Scoring Initiatives: Follow examples like the Eurosystem’s tilting methodology to integrate climate considerations into financial decisions.
- Promote Sustainable Investments: Encourage both public and private investors to direct capital towards clean technologies and responsible business practices.
By implementing these proposals, we can better manage climate risks and work towards a more sustainable and resilient future.
Authors
Claudia Antuña, partner AFI
Eric Borremans, Head of Environmental, Social & Governance, Pictet AM
Gonzalo Yebes Gómez, Senior Financial Risk Expert, Banco de España. Member of the Scientific Committee, Oxford Congress 2024
Ángel Pérez Agenjo, Founder and Managing Partner, Trascendent. Member of the Scientific Committee, Oxford Congress 2024
Oxford/24 Final Report:
This paper is part of the Fide Foundation’s GET-2 ESG Think-Tank final report from the 2024 Oxford Congress, titled “Driving Change: Exploring Opportunities and Challenges in Accelerating Sustainable Finance.” Held at Jesus College, Oxford on September 18th, 19th, and 20th, 2024, the Congress brought together world leaders in finance, regulation, and sustainability. This comprehensive report consolidates key insights from the event, offering strategic recommendations to financial institutions and regulators on transitioning to a low-carbon economy and reaching net-zero greenhouse gas emissions by 2050.
The full report can be found at: https://bit.ly/oxf24-report
