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26 november 2018 Algemeen
Frank Elderson

On the evening of the first day of the ÖNB Conference on European Economic Integration in Vienna, Frank Elderson was invited to give a dinner speech. Frank Elderson spoke about mobilizing the financial resources needed for financing the energy transition. He discussed the role of the private sector and what governments and central banks can do to facilitate and stimulate the process.

Datum: 26 november 2018
Locatie: the ÖNB Conference on European Economic Integration 2018, Wenen
Spreker: Frank Elderson

Thank you, for your kind introduction, and thank you very much for having me. It’s a great privilege for me to speak to you all at this Conference on European Economic Integration.

I hope you enjoyed the dinner and the Austrian wine as much as I did. You know, 2018 was an excellent wine year. In the Netherlands… Thanks to the very warm and dry summer, conditions were perfect for grapes to ripen. Wine is a growth sector in the Netherlands: there are about one hundred and seventy vineyards and their number is increasing. Of course, Dutch wines aren’t quite as good as those from the vineyards of the Kremstal or the Wachau, but we are catching up!

Some of you may be thinking: wait a second, the Netherlands, wasn’t that once a swampy, wind-swept river-delta with cows and sheep roaming the misty meadows? Providing the rest of Europe with milk, cheese, and famous DJs? Don’t worry, we still are. But something is changing. Ladies and gentlemen, you know where I am heading: it is the climate that’s changing, and it’s affecting us all. Which isn’t good news at all, apart from the occasional Dutch winegrower.

That is why in 2015 in Paris, nearly 200 countries -and the European Union - signed a treaty to phase out the emission of greenhouse gasses. To keep global warming well within 2 degrees. did all jurisdictions sign? Well, as you know, one rather important jurisdiction chose to backtrack from this treaty. But even there, thinking has not stopped. The Global Change Research Program, based on the input of thirteen federal agencies, published a very important report just last week – during Thanksgiving. Let me cite form its findings:

“In the absence of significant global mitigation action and regional adaptation efforts, rising temperatures, sea level rise, and changes in extreme events are expected to increasingly disrupt and damage critical infrastructure and property, labor productivity, and the vitality of our communities.”

And one more quote:

“With continued growth in emissions at historic rates, annual losses in some economic sectors are projected to reach hundreds of billions of dollars by the end of the century – more than the current gross domestic product (GDP) of many U.S. states.”

Now some people might think this was written by an NGO. But no, these are the words of thirteen U.S. Federal Agencies.

The transition to a low-carbon economy requires tremendous amounts of investment. Wind farms have to be built, houses have to switch to sustainable energy, cars have to become clean. 180 billion euros: that is the estimated additional annual investment needed in the European Union, to meet its climate targets for the year 2030. That seems like a huge sum of money, and of course it is.

But it is only slightly more than 1% of our combined GDP. Can it be done? Yes. Must it be done? Absolutely. Will it be done? That depends on all of us. So what does it take? Well basically, we need funding, we need fundable projects, and we need them to connect.

Role of the private sector

The bulk of the funding will have to come from the private financial sector. But they have to take account of their shareholders, customers – and of course their supervisors. So if they are to invest in green projects, they need business cases where risk-adjusted returns, scale and maturity are sufficiently attractive. And this is often where the main challenge lies: Many green projects lack sufficient scale, returns are only expected over a long time horizon, and perceived risk is high or still unclear.

So what needs to happen is that banks and originators of green investment projects sit around the table to work out the details to make these projects bankable. And that’s exactly what is currently going on in the Netherlands. Government, enterprise, financial sector and a lot of other stakeholders are now finalizing the negotiations on a national climate accord that sets out how we will reduce our own carbon emissions to meet our Paris commitments. This is a very complicated trajectory, but we are definitely making progress.

To give you one example: schools are usually big complexes, and therefore contribute heavily to our emissions. As they often have a flat roof, schools could easily reduce their emissions by installing solar panels. The problem is funding costs. So how do we bridge this gap?

Role of the governments

That is where governments could come into the picture. In the Netherlands a fund was created to finance sustainability initiatives at schools. Because the fund is government-guaranteed, schools can obtain these loans at very low rates of interest. The funds will lower schools’ utility costs, reducing the credit risk of these loans. In addition, the fund will also provide technical consultancy services to the schools, to optimize effectiveness. It is expected that the fund can finance the transition of some 6,000 educational institutions from brown to green energy. A shining example of public-private partnership.

But what’s even more important than helping kick-start specific projects, is that the

government creates clear and long term transition legislation. By doing so, it gives

households and companies firm grounds on which to base their investment decisions, and helps improve the business case for green investments.

The sooner there is clarity about the transition path, the sooner businesses and households adjust their investment decisions. This is important because the longer we wait, the more drastic measures will have to be taken later on. An abrupt transition will certainly be costly to the economy and threatening to financial stability. That is why we at DNB have pleaded for a national climate law for some years now.

Let me mention one elephant in the room here, and that is the CO2-tax. An effective tax on carbon emissions would address the emission problem at the root, and would function as a direct incentive for corporations to reduce their carbon footprint. The most straightforward approach would be to introduce a European carbon tax, after the example of the European Emissions Trading System (ETS).

But our research has shown that, even implementation on a national level, could stimulate development of more energy-efficient and less emission-intensive production technologies, without any major negative effects on the economy as a whole. Although this research was done specifically for the Netherlands, its conclusion may very well hold true for other countries as well.

Governments and legislators can also facilitate the financing of the energy transition by helping to transform the financial infrastructure. The European Commission’s Action Plan on Financing Sustainable Growth addresses the question how to get the financial sector to operate as a key driver for sustainable business activity. And it aims to reorient capital flows towards sustainable investment. To achieve this, it will focus on a unified EU classification system of sustainable economic activities.

This ‘taxonomy’ will create transparency and improve disclosure requirements on how institutional investors integrate environmental, social and governance factors in their risk processes. Creating a common language and bringing risk into focus will make it easier for companies and financial institutions to make investment decisions.

Role of central banks and supervisors
I now turn to central banks and financial supervisors. I think there are at least three things we as central banks can do to support the funding of the energy transition while staying within our mandates. First, economic research and advice. Second, making the sector more aware of climate risk and of the expectations of the supervisor in that regard. And third, helping to bring parties together.

Economic research and advice
For the first of these areas, economic research and advice, you probably know the pioneering work of the Bank of England. Also, through our research at the Dutch central bank, we were able to influence the national public debate. For example our report ‘Time for transition’ that came out in 2016. In that report, we urged our government to pursue a plausible and practicable path towards a low-carbon economy. That helped gain the momentum for the national climate accord that’s now being worked out.

Making the sector aware and setting supervisory expectations
The second area is risk. And I can almost hear sighs of relief among the central bankers and supervisors here in the room. Ah, “risk”… Finally a word we feel comfortable with, after all that other strange and scary stuff.

Let me explain what I mean exactly. It is increasingly recognized that climate related risks are relevant for financial institutions and that they must know, manage and possibly reduce these risks.

In our supervision we have started to pay serious attention to it, and so have others. By climate related risk I mean both the physical effects of changing climate, like extreme weather events, and risks arising from the transition to a low carbon economy, like stranded assets. Let me illustrate this with an example from our own experience.

Last year we researched how these risks may affect the financial sector. As a first step, we wanted to measure how exposed our financial industry is to sectors that need significant reforms to become carbon neutral, starting with the banks. Unsurprisingly, most of these exposures are through loans, which makes banks less sensitive to market fluctuations than for example pension funds, which are more exposed through equity or bonds. Moreover, most of these loans have short-term maturities, which should provide banks with sufficient scope to anticipate changes. Especially if the transition is more gradual in nature.

In one area however, we already see transition risks materializing, and that’s in the real estate sector. The real estate sector plays an important role in carbon emissions and is therefore sensitive to the energy transition. In the EU, many, if not all, residential and commercial real estate have energy efficiency labels, ranging from A to G. With G being the least energy-efficient buildings. The Dutch government has announced legislation that requires almost all offices in the Netherlands to have a minimum energy efficiency label of C by 2023. Any premises that doesn’t meet that requirement can no longer be used.

This affects banks in two ways. First, through loans to regular corporations, who use their own offices as collateral for their bank loans. Second, through loans to commercial real estate companies that lease offices as a business model. If some of these premises can no longer be used, or need to be upgraded to meet requirements, it could affect the value of the collateral, or the ability of commercial real estate companies to repay their loans. Hence, we see an immediate impact on the commercial real estate sector.

So how big of an issue is this for our banks? Unfortunately, at this point neither we nor our banks know the energy label distribution of the offices used as collateral for loans to regular corporations. For loans to commercial real estate companies, a sample survey of banks showed that only roughly 50% of energy labels were known for those loans. For the loans where we did know the label distribution, we found that 46% of them have an energy label lower than C.

This means that loans amounting to some 6 billion euros are vulnerable to the effects of this climate policy. You could say that all these loans have elevated credit risks, which banks, one way or the other, will need to manage. Fortunately, many banks have reacted swiftly. Banks are now demanding that any new loan or refinancing of existing loans in relation to those offices, is dependent on the client meeting the energy-label requirement on time. This should limit banks’ exposures to offices that don’t meet the deadline. For us, this national legislation is a prime example of how the energy transition will lead to risks in the financial sector.

Importantly, increased risk awareness among banks means they will gradually steer their portfolio allocation from brown to green. Many financial institutions are currently mapping their exposures to climate-related risk. That in itself stimulates their attention for green investment opportunities. An effect that will be further amplified if they have an obligation to report on these risks.

Convening power
The third thing that central banks and supervisors can do is to use their convening power to bring parties together. For example, in the Netherlands we have set up the Platform for Sustainable Development. The Platform provides a forum for the financial sector, government and supervisors. Within this platform, which I chair, we discuss how we can remove unnecessary obstacles to green finance, and how we can speak a common language when we talk about green finance. One of the Platform’s achievements has been to develop a system for measuring and reporting on the climate impact of the assets.

For those of you worried about overstepping your mandate by facilitating sustainable finance, let me say this. Ever since the Bank of England Governor Mark Carney started discussing the financial stability implications of climate change back in 2015, the view has spread that sustainability factors, and climate issues in particular, can affect the solidity of financial institutions.

This is an issue that therefore warrants the attention of banks and supervisors. Recently, the Financial Stability Board’s Task Force on Climate-related Financial Disclosures published its first status report. Only last week, the ECB’s banking supervisory arm announced that climate-related risks are key risk drivers, affecting the euro area banking system.

And last but not least, I’d like to mention the central banks and supervisors’ Network for Greening the Financial System, that I’m proud to chair. In less than a year, the network has grown from eight members to over twenty members, including the ECB, the People’s Bank of China, the Banque de France, the Bank of England, and, last but not least, our host of today, the Österreichische National Bank. And among the very active observers, are the World Bank, the BIS, the OECD and the EBRD. By sharing experiences and best practices, we aim to contribute to better climate risk management in the financial sector, and to supporting the transition toward a sustainable economy.

A few weeks ago the group published its first progress report. In this report, the network reasserts that climate-related risks fall squarely within the supervisory and financial stability mandates of central banks and supervisors. It also stresses the need to develop new analytical and supervisory approaches, including those based on forward looking scenario analysis and stress tests. With this coalition of the willing, we want to accelerate the work on greening the financial system.

Conclusion
Ladies and gentlemen, let me conclude. I have talked about the importance of mobilizing the financial resources needed for financing the energy transition. I discussed the role of the private sector and what governments and central banks can do to facilitate and stimulate the process. I hope that the alarming prospect of a world being flooded by Dutch wine has made it clear to you what is at stake here.