European green finance is expanding, a discount on bank capital would discredit it

The Commission’s ‘European Green Deal’ sets out massive investment needs in a variety of areas, amounting to potentially 1.5 per cent of the EU’s annual GDP. If these targets are to be met it is clear that in addition to the various EU and European Investment Bank (EIB) instruments, European capital markets, banks and other financial institutions will need to significantly reallocate funding. A review of how prudential regulation reflects climate risks, and how it treats green assets was mentioned in the Commission’s December policy statement. This also seems a reference to the Commissioner’s earlier statements that a ‘green supporting factor’ would be examined.

Last year’s issuance of green bonds, which designate certified projects and are marketed to an expanding investor group bound by environmental, social and governance standards, again sharply exceeded the previous year’s total of $167billion. Adoption of the EU’s green bond standard would give this market a more transparent framework, building on the various private standards for this asset class.

But bank loans, not capital markets, will continue to provide the bulk of financing. For banks to decisively expand green finance as a business line they will first and foremost need a reliable policy framework on aspects such as the carbon price or targets for renewable energy creation. The EU taxonomy would be an essential basis for defining and measuring sustainable banking. The taxonomy will also be crucial for the securitisation of green assets which could open up additional refinancing. For banks to establish this business line more firmly, public and private owners will need to set clear internal performance targets. Know-how and skills will need to be built for projects and risks that are quite different from those in traditional corporate lending.

A survey from the European Central Bank suggests that bank credit standards for loans to enterprises have consistently eased over the past two years. Competition in the industry and risk perceptions have overwhelmingly induced banks to be more forthcoming on loan terms, such as collateral requirements or margins charged. This should benefit riskier assets such as sustainable banking.

But the danger is that based on the Commission’s December announcements, EU banks may now hold off and wait for clarity on further EU measures that could support green finance. A first such measure is the expansion of credit guarantees offered by the EIB, which are offered alongside those of national promotional banks. Such guarantees can be a sensible tool where private financial institutions wrongly overestimate the risks from a green project. Yet, public guarantees of such exposures should not hold back the private sector’s own efforts to build capacity, and ultimately green bank finance needs to be a business line that stands on its own feet.

A second type of support could come from rejigging EU prudential regulation. Valdis Dombrovskis has repeatedly mooted that a ‘green supporting factor’ could reduce risk weights applied to banks’ exposures to certain types of green assets. By offering a discount on the bank capital required for such exposures, EU regulation would seek to reduce the cost and expand the availability of green finance.

Even though the Commission’s own experts, stopped well short of endorsing this concept, the idea now seems to have re-emerged. The new EU taxonomy would allow it to distinguish transparently between green and brown assets. On this basis, past default histories could become more transparent, and lower capital charges could be granted.

As yet, there is no evidence that this would be warranted, at least as long as bank soundness alone remains the objective. In fact, there are plenty of instances where higher risks transpired. For instance, a wave of insolvencies of solar panel companies has cost banks dear. Bankruptcies were caused by erratic support for renewable energy in individual member states, and unpredictable EU import tariffs. Granting reduced capital requirements to banks with a significant sustainable loan book could, therefore, be counterproductive, as more thinly capitalised banks would be penalized in bank funding markets. Moreover, implementing a supporting factor according to a borrower’s industry could penalise exposures to ‘brown’ industries that have successfully diversified into more climate-resilient activities, e.g. oil majors with significant renewable generation.

Subjecting bank soundness to the policy aim of stimulating green finance would be a mistake. And crucially, lowering capital charges may not be immediately effective. This is what the EU’s experience with a similar ‘supporting factor’ for SME lending suggests. In its initial assessment, the European Banking Authority (EBA) found no evidence that this move increased access to finance for smaller firms relative to larger firms.

That said, it is clear that the Paris Accord has created a risk differential between green and brown assets. Financial stability risks emerge from more frequent severe disasters (physical risks), and from the repricing that results in the transition towards a low-carbon economy. Such risks are long-term and only quantifiable on the basis of complex climate scenarios. Risk weights for mid-sized and large banks are typically not standardised but are produced by bank-specific models under the internal risk-based approach, using historical correlations. Climate risks are hence rarely captured by banks’ risk management frameworks (though a new EBA action plan has set out to address this).

Green finance will need to be properly skilled and driven by a consistent strategy within EU banks. Given predictable regulation and policies, this could become a profitable business line in an otherwise structurally weak sector. Skills and a clear EU framework could also be an important advantage in the substantial foreign operations of EU banks, importantly in emerging markets where sustainable investment is most needed.

Public support could bridge certain market failures, though should be otherwise limited. It should not distract from what seems primarily a challenge for the private financial industry. In the absence of good evidence to the contrary, broad discounts within the EU capital regulation would pose a grave risk for financial stability and an international level playing field.