Green Finance: The Role of the Regulator
RICHARD MONKS, DIRECTOR OF STRATEGY, FINANCIAL CONDUCT AUTHORITY
Financial markets are an essential component of modern economies. By allowing an efficient allocation of capital, they ensure that consumers can invest money in the expectation of a return, and companies can borrow money to invest and grow. Financial services are also integral to our daily lives – through the banking and payments systems which enable us to smooth lifetime income and expenditure, and protect ourselves against unforeseen events. Effective, efficient financial markets benefit those that use them – individuals, businesses and the wider economy.
Financial firms and markets will be materially impacted by climate change. As the regulator of these firms and markets, the Financial Conduct Authority (FCA) has an important role to play in ensuring that these markets continue to serve user needs.
This essay discusses the role of the FCA in respect to climate change. It argues that effective regulation helps build trust in markets and helps markets grow, and that regulation can play an important role in enabling green finance to develop. It sets out the key issues we face today, before considering how our regulatory approach could develop in the longer-term.
As the regulator for UK financial markets, the FCA’s mandate is clear: we have a strategic objective to ensure markets work well. We are here to serve the public interest and to serve users of financial services. To do this, we must anticipate future market developments, including those relating to climate change, and act to enable markets to develop in ways that meet the public interest.
Left to themselves, financial markets can prioritise short-term outcomes that in the medium and long-term do not serve the public interest. This was recognised almost 200 years ago by William Forster-Lloyds, describing how short-term individual interests can lead to the exploitation of shared resources, thus working against the public interest by neglecting the long- term implications of personal gains. 200 years later, the FCA takes a proactive role in service of the long-term public interest. We are doing this in relation to long-term investments, opening a discussion on primary capital market structures and regulation to assess whether they reinforce short-termism, and in respect of climate change.
Physical risks resulting from climate change, whether event-driven or resulting from long-term shifts, will most likely have damaging effects on the financial performance of firms. Investors struggle to identify which companies are most at risk from climate change and which ones are prepared and taking action. This affects efficient capital allocation. The transition to a low-carbon economy has begun and is being supported by legislative change. Both listed firms and regulated firms must adapt to those changes. Finally, there is a strong investor demand for ‘green’ products. For example, 78% of UK Defined Contribution members aged 22-34 feel strongly about environmental issues, and around one in four of them always boycott a brand or company because they disagree with the ethics or their behaviour.
Regulation helping market growth
Regulation has played a critical role in enabling financial markets to develop. As early as 1829, public authorities in New York recognised that deposit insurance created consumer trust in banks and enabled the sector to grow. Prudential standards facilitate fractional reserve banking and support economic growth, whilst disclosure standards enable investors to reach an informed view of traded securities in order to assess true asset value, risks, and opportunities. Without these protections in place, it is unlikely that financial markets would have enabled the huge leaps forward in living standards and GDP growth witnesses throughout the twentieth century. With this in mind, effective regulation must be part of the story of market growth, not an afterthought.
Our challenge today is to determine how financial markets will need to evolve in response to the physical effects of climate change, the transition to a low-carbon economy, and increased investor demand for green financial products. We also need to work with the industry, consumer groups, and climate scientists to understand how the FCA can enable the markets to evolve.
What good may look like
If we are to ensure that financial services markets function well and protect the investors who access these markets, we need to work with industry and consumers to anticipate and prevent future problems. But what might “good” look like for investors? It is investors being able to invest with confidence in financial products with a clear understanding of what green means. It is the absence of greenwashing and mis-labelling of ‘green’ financial products. “Good” for investors also looks like an adequate pricing of climate-risk by financial markets and the ability to measure the ‘green’ or sustainable aspect of a product, as well as its financial return.
As climate change is an unparalleled issue that commands a global response, nearly 200 governments signed the Paris Agreement in 2015 to commit to reinforcing the global response to climate change and maintain global temperature increases below a certain level. Since then, the European Union launched an action plan on sustainable finance that aims to re-orient capital flows towards sustainable investments and decarbonise the EU economy to deliver climate, environmental, and sustainability goals. In order to support the transition to a low-carbon economy and mitigate the impact of the effects of climate change on the UK financial sector, we published our Discussion Paper on climate change and green finance late in 2018.It sets out how the impacts of climate change are relevant to the FCA’s statutory objectives of protecting consumers’ market integrity and promoting competition.
Market developments and the future of regulation
Looking at the future of regulation, it seems clear that it now demands that we combine success with fairness and sustainability. We are departing from the traditional, namely more philosophical view of the purpose of regulation according to which rules are prescriptive statements that forbid, require, or permit some action or outcome. Indeed, an important and recent development in the purpose of regulation is its use to enable change consistent with our public policy objectives.
Indeed, our regulation should support the development of innovative financial products in the green finance sector to assist the UK’s transition to a low-carbon economy. That is why we launched our Green Fintech Challenge in 2018, actively encouraging the development of creative, market-led solutions in this area. Moreover, our Innovate regulatory sandbox allows businesses to test innovative products, services, business models, and delivery mechanisms in the real market, with real consumers.
Nonetheless, regulation must remain grounded in public policy objectives and in the field of public goods. Sometimes innovation will be consistent and other times it will need further guidance to get there. The nature of competition and innovation will make some businesses succeed and not others. We have never and will never be in the business of picking winners. For example, we remain neutral as to technologies and the types of firms we regulate in the areas of Fintech.
Thus, regulation is deemed to play an important multi-faceted role in climate change. Our remit is broad, ranging from underpinning tail risk mitigation to assisting a smooth transition to a low-carbon economy in the UK. But more importantly, the role of regulation with regards to climate change is to ensure markets work well in the future and work in the interest of consumers.
Read the Sustainable Finance Report here.