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Global rules on foreign direct investment (FDI)
Cross-border acquisitions and investments increasingly trigger foreign direct investment (FDI) screening requirements.
In the first article in this three part-series we explored the nature of directors’ duties in driving the ESG agenda. For financial services in particular, merely focusing on directors’ duties will not drive any meaningful change.
The regulators are aware of this, and instead often propose to approach the problem by imposing “brown penalties”. Rather than impose change through positive duties, they seek to penalise financial institutions with burdensome regulatory capital requirements if their balance sheet is too heavily “brown”. This presents a danger to financial stability, risking – as it does – the wholesale divestment of less-than-perfectly-green assets.
The regulatory response
An example of such a response can be seen in the consultation paper on the Pillar 3 disclosure framework issued by The Basel Committee on Banking Supervision in late 2023. The intention was to address climate-related financial risks in the global banking system.
In common with other climate-disclosure regimes already in force it focuses primarily on climate-related exposures of individual firms. By disincentivising individual firms from investing in brown assets the intention is to drive investment into green products.
The UK’s response is not all that different. The House of Commons Environmental Audit Committee report on the Financial Sector and the UK’s net zero transition published late last year focused on making transition plans mandatory and on reducing exposure to fossil fuels. Whilst they identify that some “brown” assets exist (in the form of housing) the proposed solution, according to the Environmental Audit Committee, is to empower local authorities to issue grants to renovate properties. There is no clear plan of where that money is to come from, or how the lack of training and knowledge within the local authority to manage such schemes is to be addressed.
The brown problem
If we consider real estate as an example (either commercial or residential) we can perhaps start to see some of the scale of the problem.
In the Eurozone, 26% of all outstanding bank loans are backed by real estate1. Real estate globally is responsible for approximately 40% of energy consumption and 36% of greenhouse gas emissions. Tackling this is clearly imperative if net zero targets are to be met.
Yet approximately 35% of properties are over 50 years old. A staggering 95% do not meet an EPC rating of A (which is required to be considered energy efficient)2. The rate of change is slow, with only 1% of properties undergoing an energy renovation each year.
The stranded assets
If 95% of real estate is not ‘energy efficient’, where will the funding come from to assist them to transition to energy efficiency? The Basel Committee proposal would, if adopted, disincentivise investment in such assets, leaving them potentially stranded and ultimately more difficult to (re-)finance.
CREFC, a leading trade organisation recently responded at length to the Basel Committee paper. The main themes emerging from that response were:
If we are to effectively manage climate-related risks, there must be recognition that the financial services industry as a whole, not just at the individual bank balance sheet level, needs to work collectively to finance the adaptation to, and mitigation of, climate risks. Individualised metrics merely disguise and shift the problem without necessarily resolving it.
Where should the focus be?
Could brown be the new green?
Depending on which models you look at, estimates vary as to the costs involved in transitioning to net zero. Taking just one of these as a guide, McKinsey (2022) estimates that achieving net-zero emissions by 2050 would require about 275 trillion U.S. dollars in cumulative spending on physical assets, or approximately 9.2 trillion dollars per year, over the next three decades. In the European Union alone, the investment needs are estimated at 28 trillion euros (McKinsey, 2020).
Whilst the brown penalising factor (i.e. higher risk-weight in capital requirements for brown assets) and the green support factor (i.e. the reverse, by lowering capital requirements for green assets) may on paper achieve the desired goal, does it perhaps only shift the problem?
Cast your mind back to your school days and you may recall the first law of thermodynamics. In simple terms it states that energy cannot be created or destroyed, it is simply changed from one form to another.
We have already seen the off-loading of fossil fuel assets by some of the big energy companies to ensure a greener balance sheet. These assets have not disappeared, they have been snapped up by private equity companies. In 2021 and 2022, private equity firms acquired at least 25 billion U.S. dollars in oil and gas assets from the public markets5. How are these assets to be refinanced once the private equity firms have exhausted the arbitrage?
We risk the exact same happening with other assets, including real estate. If financing existing brown assets becomes untenable for banks then other parties will move in to fill that void. We are not solving the problem, we are merely disguising it, and ultimately perhaps even increasing it.
In the third and final part of this three-part series we explore in more detail the incentives for green finance and how both green and brown assets must be effectively financed.
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Cross-border acquisitions and investments increasingly trigger foreign direct investment (FDI) screening requirements.
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We are delighted to announce that Al Hounsell, Director of Strategic Innovation & Legal Design based in our Toronto office, has been named 'Innovative Leader of the Year' at the International Legal Technology Association (ILTA) Awards.
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