The blind spot

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:

1. Transparency: Any disclosures that are required must be meaningful and consider the correct metrics. “Energy efficiency” is not the same as “energy intensity”, and failing to distinguish the two could lead to a mismanagement of climate-related financial risks by banks;
2. Plans not targets: Unless there is mandatory disclosure of net zero carbon plans by companies linked to actual frameworks, rather than targets, banks are unable to properly assess credit risk when lending;
3. Brown-penalty: By incentivising the removal of finance from high energy-consuming but socioeconomically necessary sectors, the transition to low-carbon is made more difficult and ultimately more costly.

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? 

1. Customer needs
   
   Property owners need assistance to transition their homes to energy efficiency. There is a variety of ways this could be addressed. For example by introducing mandatory cost assessment for renovations as part of any sale of a property. This would be similar to the mandatory EPC reports. If a standardised cost assessment methodology is used to review and map future renovation costs needed to transition towards higher EPC ratings, buyers and sellers would have greater transparency. In turn, lenders could link financing options to these transition plans.
   
   For those properties with particularly low EPCs, introducing renovation requirements as part of the lending conditions, possibly linked to favourable mortgage rates, would further increase renovation rates.
   
   Retrofitting these properties may well lead to an increase in emissions temporarily, even if the ultimate operating emissions are reduced. This must be accounted for in the disclosures that are required.
   
   The simple reality is that the majority of properties in existence are not energy efficient and the environmental cost of demolishing and rebuilding (when looked at on a ‘whole of life’ carbon basis) can far outweigh the cost of renovation.
2. Energy efficiency 
   
   Energy efficiency must not be confused with low energy or clean energy. To really understand energy efficiency there would need to be access to individual customers actual usage. However, data availability and data sharing with lenders presents significant challenges. For individual borrowers, existing privacy laws (such as GDPR) may prevent sharing of this information. Even in commercial property, building-level emissions data would require building occupiers and building managers and owners to share energy sourcing and consumption data.
   
   For data to be shared in this way there must be a framework put in place to properly protect the data. Trust also needs to be established that the data will not be used in nefarious ways.
3. Socioeconomically desirable and necessary properties
   
   Certain properties are by their nature energy intensive. Data centres, for example, are already estimated to contribute 3% globally to energy consumption, rising to 4% by 2030³. Whilst they can be naturally very energy intensive, they are also obviously necessary for modern economies and societies to function. These kinds of buildings therefore need to be made as energy efficient and low carbon-impact as possible. That however also requires capital. Care also needs to be taken to ensure we are measuring energy usage, and efficiency, in a holistic way. If you take The Netherlands as an example, between 2017 and 2021, electricity use by data centres grew from 1.5% to 3.3%⁴. That doesn’t sound good. Yet this measurement is in respect of usage by the off-site data centres as a percentage of the national grid. It doesn’t take account of the decrease in energy usage by individual companies by moving to off-premises data sites. Looking at these sites in isolation, using restrictive disclosure and risk templates, could lead to disinvestment of the exact assets we need to drive some of the ESG changes needed.

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.