Trends: Finance and the real economy necessary to resolve funding gaps

This article first appeared in Personal Wealth, The Edge Malaysia Weekly, on October 21, 2019 - October 27, 2019.
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Finance plays a pivotal role in bridging the funding gaps for climate and sustainable development projects. However, finance alone is insufficient to resolve these issues unless it meets the needs of the real economy, says Ben Caldecott, director of the Oxford Sustainable Finance Programme at the University of Oxford.

Caldecott says: “Finances is an insufficient condition… I’ve heard at some conferences where people make [proclamations] such as ‘Finances is going to save the world! A green bond is going to save the world!’ It’s not, I’m afraid.

“It might make a contribution, but we need the real economy, the real cash flows that can be financed. Without those cash flows, nothing will happen. So, [when] finance serves the real economy, we still need policy framework, we still need technological change, we need all of these things to happen.”

While finance enables these processes to happen cheaply and efficiently, the global move towards a decarbonised economy — or a low-fossil-fuel economy — will be the most capital-intensive transition in history, he points out.

This is all the more reason to work towards aligning the financial systems and mobilising sufficient capital to finance the long-term health of the real economy, he says.

“All the technologies and systems that need to be replaced require capital. For example, once they build a solar farm or a wind farm, all the capital costs are upfront and the running cost is very low. The sun is free, the wind blows for free.

“In contrast to the traditional gas fire or coal-fired power stations, most of them require costs throughout the lifetime of the asset, because you are constantly buying the fuel to burn and to upkeep the facility.

“There are big opportunities and big challenges. How do we mobilise capital efficiently? I emphasise the word ‘efficiently’ because we need to make sure the cost of capital is as low as possible.

“This is so that people can borrow the money they need and they have access to the capital that they need to make these investments, which will improve their businesses but also make a differences to these big environmental challenges,” Caldecott says, when met at the sidelines of The Cooler Earth Sustainability Summit, organised by CIMB Bank Bhd on Oct 2.

He adds that banks play an important role in making financial markets meet the real economy; they can start by introducing sustainability improvement loans.

Banks, he says, can set targets for businesses such as the positive difference that the latter’s operation makes to the environment and reduce its risk to committing damages to the environment.

“A good example is energy-efficiency. Say a bank lends money to an energy-intensive company, [they can tell them that] they are not going to renew their credit facility, unless they reduce their energy consumption by X%.

“As a bank, you will know in your credit risk model, if they reduce their energy consumption by X%, that will reduce their cost, which means that their credit profile improves. You can then share some of that with your client. That is a very positive impactful thing to do, and it should be the standard,” he says.

Caldecott points out a similar process could also be imposed on mortgages. Citing an example from the UK, where, in efforts to reduce the country’s carbon emissions, the government announced a £5 million (RM26.46 million) fund to help the financial sector develop green home finance products such as green mortgages, he says.

In turn, households are rewarded with cheaper mortgage rates by reducing their energy consumption, as homes are responsible for 15% of the UK’s carbon emissions.

“In the UK, the energy bill of an average home is about £1,500 a year. Now, if you go from a poor rating to a good rating, you can halve the bill, and the bank sees that you have £750 more each year. This means your credit rating has improved and the bank can give you a reduction in cost on capital a bit and, obviously, make some money as well,” he says.

Apart from strategies to reward good practices, the UK also plans to impose a tax on carbon dioxide emissions from power stations and factories. The UK is set to impose a £16 per tonne tax on carbon if it leaves the European Union without a deal on Oct 31. The tax would replace levies under the European Emissions Trading System, which the UK would automatically leave under a no-deal scenario.

Caldecott adds both the carrot (rewards) and stick (carbon tax) strategies are essential for change to take place. “Remember, the interest rate thing is a finance thing. Carbon tax is a real economy thing. They are operating in different parts of the systems. A lot of these should be solved through the real economy and policy, rather than through the finance systems. That should be the case, where good things we want to see happen are profitable, and the things that we don’t want to see happen aren’t profitable, and the financial system adjusts.”

Caldecott adds that sustainable-only financing options could become mainstream as risks are better identified and managed.

“Ideally, that will become completely mainstream. We need to move from a relatively niche and specialised activity to something that’s completely integrated, and there is no reason that can’t happen.

“As institutions become much more knowledgeable in terms of how to measure these risks, identify these impacts, observe these opportunities and integrate that into what they do, we can get there,” he says.

There is no need for investors to fear having to sacrifice on their financial returns to do this. Caldecott says: “In fact, this [sustainability practices] is in part about enhancing returns and managing risks much more effectively. There is a lot of evidence that suggests that corporates that adopt sustainability practices become much more efficient, make more money, and see their share prices increase and their cost of capital reduced. That is kind of a win-win situation.

“Many of them [financial institutions] have actually lost a lot of money because they probably haven’t been pricing in these risks and opportunities. They haven’t been observing them or been systematic about them.”

As for investors, he says, it is important that they turn their focus to risk management. “Manage your exposure. Reduce your exposure to those [companies] with high risk.”

“How do you identify things that are high-risk? We can have that conversation on the different ways of doing it, but some investors have a really strong conviction. Given the pace of the transition that we are seeing, for example, in transportation, there is not a huge amount of upside in international companies such as oil and gas companies.

“There is also the fact that they are being pushed away and crowded out by national oil companies, which have cheaper resources and reserves. Why would you invest in them, then? Because they generate yield and pay a lot of dividends for now.

“So, you have to find a balance between what is fundamentally exposing you to a lot of risk in any other future scenario, and potentially a lot of risks, but not a huge amount of upside. If you are in that industry, reducing your exposure overtime and finding other sources of yield seems to be a good strategy,” Caldecott says.