Commentary

What can the Bank of England and Volkswagen tell us about future-proofing the Capital Markets Union?

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What can the Bank of England and Volkswagen tell us about future-proofing the Capital Markets Union?

In the effort to ‘shift the trillions’ to support the EU’s transition to sustainable economy, two important events have happened this week.

Firstly, on Tuesday night Bank of England Governor Mark Carney unveiled the long-awaited results of the Bank’s probe into the risk posed by climate change and carbon bubble to financial stability. The Governor concludes that the while the markets are not at risk right now the ‘perfect storm’ of physical risk to infrastructure from climate change events, value at risk from the carbon bubble, and the threat of fiduciary duty-related litigation does present a systemic risk to financial markets. In turn this means that the markets can’t simply be left to manage the fall out of the transition to the low carbon economy and that financial regulators do have a role to play in driving forward an orderly transition.

What will happen next is unclear. This is unchartered territory for financial regulators, and the most likely next step will be to set up a task force to set about turning the aspiration to these risks into action. Inspiration can be drawn from the new legislation brought forward by the French Government – which is already pushing ahead with regulation to manage systemic risk to its finance sector. Pension funds, insurance companies and other institutional investors in France will be required to disclose how they are managing climate change risks. It is the first country in the world to introduce a carbon reporting obligation on financial institutions. As such it paves the way for other countries, and indeed the EU collectively, to follow suit.

This is a top down approach to mainstreaming what forward-thinking socially responsible investors have been doing for years. This small but rapidly growing number of investors is increasingly aware that current business models and wider economic activity that assumes unlimited natural resources are not sustainable, and are creating systemic risks. As such they already place a value on company performance on environmental, social and governance (ESG) factors, then including that into both investment decisions and shareholder engagement activities. Why do they do this? Because more sustainable companies generally outperform less sustainable ones.

As the recent Volkswagen scandal over faked emissions testing demonstrates, this is not just wishful thinking. What businesses do and say on ESG issues (the Volkswagen scandal ticks all three of these boxes) does matter. Given that it was known that Volkswagen and other car manufacturers were cheating in emissions tests, obvious questions are raised about why it took so long for the mainstream markets to react. It seems to indicate that current ESG risk management systems are inadequate and need further strengthening in the face of increasingly non-trivial financial risks.

The Volkswagen scandal, which saw the company’s share value plunge 30%, is only the latest in a long line of examples of companies failing to fully manage environmental risks – and paying the price. In June 2015 BP's rating outlook was downgraded by Fitch Ratings because it expected lower crude oil prices but also because of fines related to the Macondo oil spill, which are expected to cut cash flows and drive up debt. BP has already paid out more than $28bn for the Macondo disaster and set aside a total of $43.8bn relating to the spill. Closer to home in the EU utility sector, the top 20 energy utilities in Europe saw over half of their €1 trillion market value wiped out in the period 2008 to 2013.

So it is timely that the Bank of England’s announcements come one day ahead of second big event – the launch of European Commission’s Capital Markets Union Action Plan.

The Capital Markets Union is an important venue of change for shifting finance system. It represents a set of new opportunities to build the regulatory and institutional architecture needed to support the realignment of capital and advance the transition to a sustainable and resilient EU economy. Given the information is the lifeblood of capital markets, this will require greater disclosure on ESG issues.

The trouble is that there is a general pushback on’ Brussels red tape’ as being anti-growth and burdensome Brussels interference. This combined with vociferous complaints from banks about the burden of disclosure means that there will need to be a strong set of arguments made to support the case for intervention on climate and ESG risk issues coming from the Commission.

The Volkswagen scandal along with the Bank of England announcements will help make the case that the benefits of greater visibility and disclosure on climate and wider ESG risks outweigh costs. The question will be what the European Commission does with that information. Financial ecosystems change slowly and the European Commission has already said the Capital Markets Union initiative will run over several years. We are likely to see some mention of sustainability issues within the Action Plan, which will be commendable. But moving forward more will need to be done.

A simple next step – following the lead of the Bank of England could be to set up a Task Force to report to DG FISMA within 6 months on the materiality of climate-related risk to capital market stability and options for addressing this within the Capital Markets Union. It should draw on the existing evidence base available in the academic and publicly available literature but also draw on international experience of assessing and managing such risk in jurisdictions including the UK, Brazil and China. Part of the remit of the Task Force, and consideration should be given to whether and how the European Systemic Risk Board could play a strengthened role, should include managing and monitoring emergent risk in the capital markets in conjunction with efforts led by the Bank for International Settlements and the Financial Stability Board at the global level.

From there the Commission can determine the case for a legitimate mandate to look a wider ESG risk and means to help capital markets identify and manage these risks. Initial analysis and best practice from a number of EU Member State suggests that this can be achieved. But that it will require a purposeful move toward creating opportunities to better align interests between all market participants over the long term.

In doing this we can move on and learn from the lessons of Volkswagen and other corporate ESG scandals. Better information and oversight opens opportunities to create capital markets that are well informed, have investment practices that are transparent and accountable, and institutions that are flexible enough to make the real economy investments needed to deliver a climate-resilient economy.

That is something that savers and society can get behind. That’s a Capital Markets Union worth having.

This project has received funding from the European Commission through a LIFE grant. The content of this section reflects only the author's view.

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