Tilting the scales, how our research identified a strategic barrier to the energy transition

Our research identifies structural bias in financial accounting rules that could strongly limit the amount of finance available for the green transition. We call for an urgent update to European financial regulations to meet climate change policies and deliver a fast energy transition.
Tilting the scales, how our research identified a strategic barrier to the energy transition
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The background:  analysing one of the world's most heavily regulated industries.

For decades people concerned about climate change have known that the key to a successful shift from fossil fuels to renewable energy has been getting the financial system behind the energy transition. Banks and the financial sector are among the most heavily regulated industries on the planet and for good reason. The key question has been how to leverage regulations in such a highly institutionalised sector to meet global energy policy goals.

To date, most research has focused on introducing new policies or amendments of existing policies in the sector aimed at making carbon intensive industries relatively less appealing than low carbon ones. For example, by introducing additional capital requirements for lending to carbon intensive firms. These approaches, which have been extensively canvassed in the literature, have not always gained the traction needed from policy-makers.

Our research team of economists from the University of Oxford and London School of Economics looked at a second, largely neglected question; namely whether the existing financial regulations could be negatively contributing to the net zero carbon transition. We found that this could in fact be the case. Regulators and supervisors may have good reasons for not introducing new policies or amending the existing ones for broader societal objectives, possibly beyond their remits; but they should not neglect how existing regulations could contribute to the build-up of climate related risk in the system and, in turn, impair the transition.

Here at the Institute for New Economic Thinking at the Oxford Martin School, delivering the energy transition has become a keen focus of our research.  We have looked at the issue from various perspectives, analysing opportunities and impediments . Our recent paper in Joule modelled transition scenarios and showed that a faster energy transition could save the world £12 trillion.  Our recent comment piece in Nature Energy called for new economic modelling to help deliver this transition, arguing that the ambition of policymakers had surpassed the capacity of the existing economic modelling for the first time.

In our paper published today in Nature Climate Change, using a large dataset from the European Banking Authority transparency exercise, we set about a methodology to determine whether existing regulations are in fact tilting the scales away from renewables.  We found that backward-looking financial models were in fact doing this, favouring fossil fuel investments, holding back renewable investment, and impeding a fast and cost-effective energy-transition in Europe.

The findings:  Backward-looking regulations favour investment in high-carbon industries

 Our research found that structural bias in financial accounting rules could strongly limit the amount of finance available for the green transition.  Backward-looking regulations inflated the risk for low-carbon investments.  Our study found that an implicit bias existed in financial accounting rules - a key driver of the profitability of banks – which inflates the cost of divesting from high carbon industries towards renewables. 

Under European financial regulations, banks must account for risk in firms and investments.  Capital requirements, for example, force banks to hold higher capital buffers for investments that are estimated to be riskier.  However, during a detailed analysis of the data, our research team found that the statistical models that are widely used by banks to comply with these regulations produce lower risk estimates for high carbon (1.8%) than low carbon sectors (3.4%).  The difference was likely caused by the backward-looking nature of financial models. 

 We found that this gap produces a significant implication for banks’ return on capital and profitability, heavily influencing management decisions, and creating artificial disincentives for financial institutions to divest their portfolios from high carbon assets.

 Implications:  A call for an urgent update to global financial regulations to meet climate change policies and deliver a fast energy transition.

 Our research highlighted a structural barrier to achieving net zero in Europe that hadn’t been widely talked about. Similar regulations based on international regulatory bodies such as the Bank of International Settlements (BIS) and the International Financial Standards Board (IFRS) could have a comparable effect on a global scale.

Financial regulations are extremely important.  They provide the guidelines for the financial system to work properly.  However financial regulations might have some side effects.  In this paper we show that some types of financial regulation might create disincentives to banks to divest from carbon intensive activities.  By doing so they might slow down the investments required for a clean energy transition.  Financial, supervisors, regulators, standard-setting bodies might consider this in their work.  Further research is also needed to better understand how this might impact broader environmental objectives.

 It is vital that banking regulation is updated to more accurately reflect the risks of investment.  Our team’s research found that existing banking regulation may be inadvertently tilting the scales toward banks’ lending to polluting fossil fuel companies and away from clean energy companies.  The reason for this is that banking regulations rely backwards on estimates of the risks which may be a poor proxy for the future. This makes it look more appealing and less risky investing in carbon intensive sectors rather than low carbon ones. The solution to this bias is that banking regulation needs to be updated to a more forward-looking approach, to take into account the fact that clean energy technologies are now much cheaper, supported by policy and less risky, and doing this will help shift capital toward the clean energy future.

 With research showing that a fast energy transition would save the world £12 trillion, we are calling for European financial regulations to be urgently updated to reflect risk more accurately.  The research we published in the journal Joule in 2022 showed there was strong economic incentives for a fast energy transition as it could save the world trillions due to investment in clean energy technologies like solar, wind and batteries, driving down total energy system costs.  As we inevitably undertake this major economic transition to clean energy, the historically low risk of high carbon energy becomes an increasingly unreliable predictor of their future risk. The financial regulations need to be urgently updated to address this new source of systemic risk for the banks.

Matteo Gasparini is a DPhil (PhD) candidate at University of Oxford's Smith School of Enterprise and Environment (SSEE) and the Institute for New Economic Thinking (INET).

Links:

Paper:  Model-based financial regulations impair the transition to net-zero carbon emissions | Nature Climate Change

Policy Brief: Model-based financial regulation challenges for the net-zero transition | Nature Climate Change

Video Explainer:  Matteo Gasparini explains recent research on banking regulation (youtube.com)

Second Video Explainer:  Eric Beinhocker: Model based financial regulations impair the transition to net zero (youtube.com)

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Climate Sciences
Physical Sciences > Earth and Environmental Sciences > Earth Sciences > Climate Sciences
International Finance
Humanities and Social Sciences > Economics > International Economics > International Finance
Energy Policy, Economics and Management
Physical Sciences > Earth and Environmental Sciences > Environmental Sciences > Energy Policy, Economics and Management
Energy System Transformation
Humanities and Social Sciences > Politics and International Studies > Public Policy > Energy System Transformation