Why; or Why Not?
Prompted by a single question, “What action can be taken by financial regulators to methodically and rapidly
grow the response to the consequences of climate change”?
In this paper, we consider three fields to draw our
conclusions
- The
global influencers
- History of innovation and a time line of its
development and obsolescence
- List of what to do and why.
Global Influencers
The Bond Market
President Clinton’s political advisor said:
“I used to think that if there was reincarnation, I wanted to come back
as the president or the pope or as a .400 baseball hitter. But now I would like
to come back as the bond market. You can intimidate everybody."[i]
Everybody with some financial nous knew exactly what he meant. It is unregulated and so big, no country or
government or company can influence it.
The bond market tells of the embedded learning of the past and
projects it into the future, for countries, governments and companies. Ten, twenty and thirty years forward. Sometimes this future forecast appears wrong,
however as that future draws nearer, the bond market reacts to reality and
quickly corrects.
The reason it has such intimidation powers and influence is its
sheer weight and size, and the timeliness of the information flowing to its
traders. It is typically an OTC market
for wholesale investors connected by electronic communication and operating 24
hours. Its constantly “live”, sometimes
trading in nanoseconds. Billions have
been made in less time.
The retail market has some access to this market through ETFs
listed on stock exchanges around the world.
However, the OTC bond market is the truthteller, the seer. News reaches the bond market more quickly
than any other market, good and bad, and the bond market reacts seemingly
instantaneously. And that is why it is
often the canary in the mine for values of stock markets, property markets, commodity
markets and all other markets that feed on it.
It inherently tells the stories of countries and companies. Of economies, risk and reward, and currencies. And if you slice and dice it enough it well tell
you about demographics, government and company policies and performance,
poverty and wealth, equality, and so it goes.
However, the bond market isn’t just a mirror reflecting the past
and the future, it has enormous and forceful influence as it is often described
as the invisible hand. Of all the
influencers discussed herein, it holds the greatest. Because of its power over governments,
companies and its investors and creators, what the bond market says, people
usually do. The bond market touches
every one and it matters to everyone.
Influencers reliant on the Bond Market
Bonds form the asset / investment base of some of our lesser global
influencers such as insurance companies, governments and pension funds. It is the funding resource that other
influencers use to create their business model and profits such as banks,
rating agencies, and companies. And it
provides financing for companies, governments and multinationals for the common
good or to create jobs, to drive growth and profits, commercialisation of
innovation, and poverty alleviation.
Indirectly it funds or feeds your home, your small business, the
investments in your pension fund.
Maybe the argument that you cannot influence the bond market is
overdone. You can influence the bond market.
You just cannot do it country by country, company by company, government
by government.
You can
influence it by making it mandatory for an “all in” recognition of climate
change. In the end the bond market is made up of people and structures and
supporting policies of regulators.
So, it is these entities that are now explored. How can we
influence the participants in the bond market to respond to what has been
called a “crisis of the planet”: climate
change?
Bank of International Settlements “BIS”
One would imagine if there was a body that needed to
understand the risk of climate change for its constituency it would be the
central bank of the central banks around the world. Right?
One had hoped we had learnt from the Great Depression of
early last century, only to experience the Great Recession of early this
century. The latter on the BIS
watch.
Those “Greats”, ultimately became banking crisis’, and
caused massive wealth destruction to the commons, from which developed
countries still struggle to emerge from the latter Great. (There is more, but for the sake of
brevity). All for the lack of
foreseeability of what should have been foreseeable, at least in the latter
Great.
Yet we know with absolute certainty that the coming banking calamity
from the effects of climate change will make both those two Greats the
equivalent of a slap in the face with lettuce leaf. From massive property destruction supporting
the loans of banks, to unusable assets such as coal reserves and power
stations, to widespread poverty and refugee movements, to food destruction and
lost water resources, to floods and fire. This isn’t speculation, this we know
as well as we know the sun will rise.
Visit BIS’s website, and the papers in the library and there
is nil, nought, nada, nothing, you get the picture. There are no dedicated committees nor throw
away lines in recent annual reports; with one glorious exception (which doesn’t
mention climate change, see later).
The closest it comes to a crisis in its latest
annual report
[ii]
is to discuss early warning indicator for a banking crisis that needs watching: “
"Credit-to-GDP gaps have reached levels signalling elevated risks in a
number of emerging market economies," it said. “The banking system is as badly stretched in parts of Asia as it was in
Europe and America in 2008, though this time Canada has also blown through the
safety barrier, with a roaring property boom. The BIS stress model measures how
far credit growth has raced ahead of trend rates for each economy.”” Etc.
So we know BIS does have a stress model.
Moving through its
comments, it concludes: “… the only way
for the world to dig itself out of this hole is to raise productivity from its
current anaemic levels. Countries must reform and shift fiscal policy from
consumption to investment.”
Those cognisant of
climate change economic opportunities would not agree more: dig itself out of the hole with investment in
adaptation and mitigation projects. How
about that? If only the BIS had added
those last words it would have been off the hook, and also achieved exactly
what it wanted with respect to fiscal policy.
Both the Australian
central bank, RBA, and the UK, have made it mandatory for their financial constituents
to report on the effects of climate change.
It has already had an impact, with the Australian banks no longer
funding coal mines or new coal power generators. So mandatory assessing of a bank’s balance
sheet for climate change does work.
Now that glorious
exception. In BIS library[iii] under Game Theory is an
excellent paper[iv]
on the transfer of wealth from generation to generation. Well worth a read. Essentially “If one assumes that within each generation, people derive their
utility from – among other things – the utility of their children, then there
logically follows an infinite-horizon planning problem: the parents care for
children who care for grandchildren who care for great-grandchildren, etc.”. Not a word in this paper about whether there
will be wealth, nor great- grandchildren, as a consequence of climate change.
Wilful blindness?
Insurance Sector
The insurance market is all over the climate change
issue. Whether its risk coverage is
appropriate, and with new initiatives.
For example, its initiative in Malawi dealing with drought (which failed,
but good effort) or its non-inclusion of coverage for flood prone or rising sea
prone properties unless substantive adaptation/mitigation has occurred, or its eye
watering premium prices for “get lost” risk in cyclone regions. This is the underwriting end of the business.
Further, with enormous wealth invested in the bond market,
it is implementing investment policies and strategies and guidelines that
preclude investment in the bonds of, say oil companies, coal companies, and
implementing ESG analysis within their asset portfolios. This is the investment end of the insurance
business.
As investors, there are global alliances / associations
established that prescribe and research the effects of climate change.
However, it still has its limitations if we go to the global
underwriting organisation, International Underwriters Association
[v]
(IUA) based in the UK. This part of the
business is where it all begins, underwriting the incoming risk. Without this part, the rest (underwriting and
investment) doesn’t exist.
One would imagine that the underwriters of the risk, the
raison d’etre of insurance companies, would be all over the coming tsunami of
risk arising from climate change. But
you would be wrong. The IUA represents
companies that trade (risk) in the London Insurance market outside Lloyds, and
include branches or subsidiaries of nearly all the world’s largest insurance
and reinsurance companies.
Its key priorities are (i) Processing efficiency and
business attraction, (ii) Promoting expertise and innovation in underwriting
and claims (iii) Influencing public policy and compliance. Search its website about climate change, and
zip, zero, nada, nil, nought etc.
It does have an Environmental Committee which has published 3
papers: but they do not address the
underwriting claims from climate change, but rather legacy problems from
environmental harm such as spilled oil, building dust.
We do not mention the claims management side of the
insurance industry here. But surely,
they are quivering in their boots.
Stock exchanges and Corporate bond issuers
Stock exchanges have almost the smallest influence on the
bond market. Notwithstanding, their
influence as both market makers, back stop, and also regulators does provide
some indirect effect. NDCi-Global
recently covered the global stock markets in a piece called The Greening of
Stock Exchanges
[vi],
which appeared to highlight that it is the developing economy stock exchanges
introducing mandatory climate change risk reporting, leading the pack, rather
than the global behemoths. This seems rational, after all developing economies
have the most to gain and the least to lose by effectively leapfrogging the
industrial age of developed economies and the concomitant climate change
consequences.
However, that NDCi-Global report does end with some comments
about those corporate issuers that listed on the stock exchanges, although not the
largest part of the bond market, are certainly relevant participants in an “all
in” argument. Here is what it had to say
about corporate governance of these corporations:
Just issued, the 2017 edition of the OECD Corporate Governance
Factbook provides the first comparative report on corporate governance across
all OECD, G20 and Financial Stability Board member jurisdictions. The report
now covers 47 different jurisdictions hosting 95% of all publicly traded
corporations in the world as measured by market value.
It specifically covers, therefore, the entities listed on stock
exchanges. In reading its 144 pages, there is not one mention of climate
change, ESG, or the Paris Agreement.
Maybe it is time that it was made mandatory for all listed
companies and funds on the stock exchanges globally to commence reporting on
the risks to their business of the consequences of climate change. Board risk
committees have a legal obligation to consider and report to the board, and
through them, to shareholders, all significant risks.
If they consider there are no risks from climate change, they should
report that also. And let shareholders value them on that basis.
Again, a major failure to consider the consequences of
climate change and certainly to influence the bond market into which those
corporates may be issuing bonds.
Pensions Funds, Funds Management and other
investors in the Bond Market
There is no question from research that a large part of this
market is switching to either ESG reporting or investment mandates or
guidelines around climate change, or they are not. The latter we won’t discuss because clearly
they will be broke soon and gone.
Do this group have influence? You bet.
If this group goes “all in”
on a mandatory basis (except those outliers that will soon die) then the bond
market would struggle if it is not green.
Arbitrageurs borrow stock from this market to make profits. Banks and other issuers rely on its long term
stable funding to finance their business models. Rating agencies have embedded their business
model and brands into the investment mandates of the buyer of bonds. Governments and multinationals also rely on
this investing market to fund government policies and infrastructure to improve
poverty or economies.
This group is influential and should be, but is it influential
enough? Soon enough?
The Green Bond Market
And now to the smallest and least influential influencer of
the bond market. The green bond market. The one key element missing from the green
bond market is size. Is this important?
It the investment community is investing in green and
adopting the ESG guidelines and other relevant policies, what is the
problem. Well there are three, and they
rotate around liquidity and duration which comes from the size of this market. For the sake of brevity, investors in the
green bond market would prefer a deep and liquid market with durations (of
specific bond portfolios) to range from the short(ish) term of say one year,
and out to 30+ years. A deep and liquid
market means a very large quantity where at any given time there are many, many
buyers and sellers to make a market.
Because the only time you need a very deep and liquid
market, is when every bond holder is heading for the exit. The deeper the market, certainly the more
sellers, but there are also more investors potentially on the other side: buyers.
This is a particular barrier for investors with specific
duration and liquidity criteria built into the mandates. Mandates mean just that, the investing fund
is mandated to buy only certain bonds of a specific maturities and depth of
market.
The third key element is ratings. More than 50% of the investment market
comprises investors with either policy or mandated ratings of say investment
grade bonds.
So the size of the market for the purposes of liquidity
(whether unaggregated – currency / rating / maturity or by issuer) and pari
passu portfolios from a rating perspective.
However, although the least influential now due to size,
wait and watch. It is the smallest
participant in the global bond market but with the most exponential growth, and
so its influence will grow both within it and likely outpace it.
Others
There is one other sub group that influencers markets and
therefore indirectly the above participants.
They are the valuers.
If we search the property valuers website, where within
their Competency Framework for Professional Valuers there is nothing nada, etc
on climate change.
If we search the equity and bond valuers website, Certified Financial
Analysts, they have training modules on climate change. Further, they say an
ESG investing ethos embodies their efforts to promote a fiduciary culture and a
more sustainable form of capitalism through their Future of Finance initiative.
They go on to say, this is a global
effort to shape a more trustworthy, forward-thinking financial industry that
better serves society.
And we do not include what some people may think are obvious: ratings agencies, accountants, and
auditors. They all take fees from the
above influencers and thus, as has been proven again and again, are more
influenced by their source of income than valuing externalities even if they
are as obvious as their own nose.
History of innovation
The only personal observations I would like to make in this
paper comes from my great age. The first
is I am still surprised at how long it takes for new and obvious innovation to
become ubiquitous. The second is how
fast the effects of climate change are occurring: well within my lifetime. Both of these are concerning for I am part of
the baby boomer bump of western countries.
Clearly, the response to both those “surprises” is to move
more quickly with the first and slow down the second.
Financial Innovation Example in times of Crisis
If ever there was a similar (if lesser) crisis confronting
the world it was the second World War, or WWII.
Financing its participation in WWII for the USA was as urgent and
unquestionably imperative as what climate change must be considered today. Its target of US$300 billion was ultimately
spent on its part to win the war. From 1939 until 1945 the Federal budget
swelled from US$9 billion to US$98 billion.
A factor of 10 in five years.
So how did it do it? It
issued innovative financial instruments that had never been used before with a
blanket advertising campaign that was so compelling it worked. Albeit, taxation did rise also, but more than
half of that money was borrowed from the American people. That is, almost two
thirds of its financing came from the people.
To put some more flavour on that effort, the population of
the USA in 1939 was 131 million, so circa US$1500 was raised from every man
women and child. The populations today
is 326 million; raising and equivalent of US$489 billion (on a straight line
basis) or after allowing for inflation, US$8.3 trillion. Put another way, the current US government
debt is US$20 trillion
[vii],
so if we increased that 10 times in six years to fund the climate change
crisis…….okay we won’t go there. But the
point is made.
The innovation included Defense Bonds at a price of
US$18.75, 10 year bullet maturity of US$25.
Also available was part of a bond, whereby people could buy a 10 cent
stamp and when their book was full they got the bond. Everybody could participate, poor rich
everybody.
The advertising campaign was phenomenal in its scope
[viii]. Rallies were held with celebrities; and a tour
of Norman Rockwell’s paintings around the country raised US$132 million; Bond
Booths were set up wherever people congregated; and the Dept Treasury endorsed
radio and TV shows that profiled the War Bonds.
The innovation and scale and scope of this fund raising for
Defense Bonds has not occurred again.
However, there is a history of how, with the will and the recognition of
a similar if lesser crisis than climate change, funding can be found to
mitigate that crisis.
So Governments are Where; Innovation and its roll out
It is often said of governments that when the hand of the
market fails, governments intervene.
Most people assume that means after the market has failed, as in the
recent Great Recession when governments around the world stepped in and rescued
the financial system, whether local or global, from the Great Recession
becoming the Great Its All Over. That is, post
the event.
However, the governments around the world are typically at
the forefront of innovation. If we look
at the smartphone in your hand today, it would not exist without government
innovation.
[ix]
In a book published in 2013 (and much awarded), The Entrepreneurial State
[x],
the somewhat invisible hand shows that pretty much governments are behind all
innovation we use today. Quoting examples:
The
book comprehensively debunks the myth of a lumbering, bureaucratic state versus
a dynamic, innovative private sector. In a series of case studies—from IT,
biotech, nanotech to today’s emerging green tech—Professor Mazzucato shows that
the opposite is true: the private sector only finds the courage to invest after
an entrepreneurial state has made the high-risk investments. In an intensely
researched chapter, she reveals that every technology that makes the iPhone so
‘smart’ was government funded: the Internet, GPS, its touch-screen display and
the voice-activated Siri.
That is, the government is active “pre” so-called market
innovation, and not only “post” market failure.
Think, who first rolled out the trains, planes,
telecommunications, sewerage, electricity plants, roads, bridges, waste
management, law and order, education, shipping, health care, etc? As a consequence of this innovative government
intervention – great industries were born, substantial poverty was alleviated,
new trade guilds were created, and previously great industries were laid waste.
And just to conclude this point, the bond market would not
be of the size, influence and diversity it is today without the governments
issuing bonds to fund their investments.
This is obvious when we are reminded that non-government bonds in any
country are priced at a margin to sovereign (sometimes notional, government) bonds.
The chicken came before the egg.
Much of financial innovation that occurred post government
intervention from the private sector such as banks and so on, (bank bills,
liquidity, structured finance, securitisation, etc) came post the development
of the government financial instruments. For example the securitisation markets
in the USA, where it started, and Australia, the second country to adopt this
funding method for home ownership, were both driven by government policy and
involvement at the commencement stage.
However, there is one overriding issue surrounding this
innovation by the government, it took the private sector decades mostly, to
make the products ubiquitous.
What to do and why.
Every following action that follows would meet the
guidelines for adaptation and mitigation NDCs of 144 countries that signed the
Paris Agreement. These actions for each country would count as a contribution
to the NDC commitments.
The
World Bank states that “an economy's financial markets are critical to its
overall development. Banking systems and stock markets enhance growth, the main
factor in poverty reduction. Strong financial systems provide reliable and
accessible information that lowers transaction costs, which in turn bolsters
resource allocation and economic growth”.
http://data.worldbank.org/topic/financial-sector
[xi]
These are presented as cascading priorities.
1. The
governments of the Paris Agreement should issue sovereign rated Green Bonds in
the size and maturity profile to create a substantial and liquid market. This
is not an arbitrary ambition. The
central bank of central banks has overtly called on governments to do exactly this
to invest in infrastructure. The experts
in this field speak of ~US$8 trillions required to be spent based on known and
quantifiable projects to adapt to or mitigate climate change. Using
gap analysis, the only thing missing is the doing.
a.
It has the obvious benefit of overcoming the
persistent stagflation / miflation and stagnation in the economies around the
world in both developing and developed economies. This would create deep and liquid markets,
and set sovereign benchmark pricing for the private sector (such as corporates)
and multinationals to price against. Dollar volumes, by way of guidance, could
be on a per capita or per GDP basis.
b.
The preference that these bonds would be either
invested in domestic green banks dedicated to building out new infrastructure
that would replace clearly obsolete infrastructure and technology.
c.
In the alternative, it could form part of the
funds committed to lesser developed countries for their green banks to invest
in adaptation and mitigation projects.
d.
In a final alternative, these bonds would be tagged
for investment in green projects, but warehoused until they come to fruition.
Most of the major infrastructure projects have significant lead times.
e.
Inherently this would engage a very small part
of the government other than the will to proceed as the vast majority of the heavy
work would be done, or outsourced to, the private sector, who would do much of
the heavy lifting; however it would create a technological transformation in
its workforce, alleviate poverty and shift towards and sustainable future. And
meet the Central Bank’s (BIS) request for investment in infrastructure to
enhance economies (see prior).
2.
That global financial system supervisors: The Bank of International Settlements, the
Basel Committee on Banking Supervision, the International Organisation of
Securities Commission, the International Association of Insurance Supervisor
and the Committee on the Global Financial System (none of whose website search fields have anything on climate change)
convene a Forum to discuss and develop consistent and cross industry policies
to create resilient constituents in the face of the rising risk from climate
change. In the process consider:
a.
Accept that the risk weighting of government
green bonds for capital adequacy purposes would continue as zero. Amend the nominal risk weighting of green
bonds from other issuers (with explicit criteria) with a say 25% discount to a
comparable asset class or bond; including those issued by multinational,
companies, banks or other issuers.
b.
Create mandatory public reporting of balance
sheet risk arising from the effects of climate change to both improve the
strength of the global financial system and aid the development of green
financing in investment and risk taking.
c.
Facilitate the adoption of the liquidity window
/ discount window / marginal lending facility / and the liquidity swaps
agreements of the New York Fed (and other governments
[xii])
to enable Green Bonds to have a greater discount rate / repo rate / base rate
than traditional Bonds other than sovereign to enhance the holding of Green
Bonds as collateral for risk weighting purposes, and to enhance the liquidity
of these bonds.
d.
Use traditional transition periods to enable
calm and contemplative shift towards full adoption of these policies. For
example, the two key components of the reporting could contemplate risk as a
probability tilting toward inevitability.
3.
The licensing regimes for employees in all these
industries (insurance banking stocks Investments, etc), that all require
continuous annual education, ensure that it becomes mandatory that three
modules of climate change education be introduced. (i) Elementary climate change issues (ii)
climate change and the risk to your business (iii) valuing the consequences of
climate change, including long term.
a.
This will quickly train hundreds of thousands of
employees in these industries around the world / alert them to potential risks
/ facilitate present and future leaders have a long lead time (if necessary) to
embed within the cultures of their institutions a deep and broad understanding
of climate change.
b.
This will be relevant whether as part of
continuing education to maintain the license qualification or for new entrants
entering the industry and wishing to acquire a licence when qualified
c.
This licensing education regime would be
relevant whether held under an umbrella license of an institution; an
individual basis; or financial services segment basis.
d.
For some countries it would be part of the
various legislation or regulation (Companies Code / Corporations Act / Listing
Rules etc) of companies / banks / insurance companies / industry bodies such as
Company Directors Associations
e.
Robust and strengthened global financial
institutions will result as a consequence.
4.
Governments that are signatories to the Paris
Agreement ensure that all professional organisations within their purview also
adopt similar training modules to enhance the opacity of reporting and
consistency. As a direct consequence,
first not so much as to dictate the truth of climate change as to ensure that
when people are reporting on climate change (for their firm, institute,
government, etc) they can speak with authority as to (i) why they are not
detailing risks / implications or (ii) what the risks and implications are.
That is, if they do not agree that climate change exists, they may at least be
informed as to why not.
5. Buy and release to all schools throughout each
country the rights to “An Inconvenient
Sequel: Truth to Power”.
The End
[iv]
http://www.nbp.pl/publikacje/materialy_i_studia/71_en.pdf
[vi]
http://ndci.global/briefing-the-greening-of-stock-exchanges/
[vii]
https://www.thebalance.com/who-owns-the-u-s-national-debt-3306124
[viii] https://www.oldradioshows.org/2011/01/war-bonds-on-radio/
[x] https://marianamazzucato.com/entrepreneurial-state/
[xi]
http://data.worldbank.org/topic/financial-sector
