The Challenge of a Glass of Water

How can financial markets be incentivised to fund sustainable infrastructure? This podcast aims to answer this question.

Transitioning the global economy to low carbon will require roughly USD100 trillion of sustainable infrastructure – renewable energy, sewage treatment and water treatment – by 2035, according to estimates by the New Climate Economy.

What, then, are the right incentives for capital markets to help fund sustainable infrastructure, if governments are either unable or unwilling to finance this spending? According to Michael Sheren, Senior Adviser within the Bank of England and Chair of the G20 Sustainable Finance Study Group, this challenge is best conceived by the example of a glass of water.

“Assume the Bank of England paid GBP0.50 [for a glass of water],” Sheren said in a podcast hosted by Jason Mitchell, Co-Head of Responsible Investment at Man Group. “Well, there was carbon used in manufacturing it in terms of energy. It might have been packaged in plastic. Customers might have digital information that may have been misused. It would have been transported. If every corporation priced their products and services and eliminated all the negative externalities that they’re free-riding on right now, this glass could cost, let’s say, GBP3.00.”

This free-riding carries profound consequences, both environmentally as well as for capital markets.

In contrast, imagine if negative externalities were factored into the cost of goods and services. Highly-polluting industries would become less viable, with money moving in a different direction, toward low-carbon industries. The consequences for markets would be significant. Firms would shift modes of production towards low-carbon formats, re-directing cash flow toward capital expenditures. In short, the transition would require a full re-assessment of the present value of stocks and bonds.

However, with increasing regulatory efforts to identify and penalise these externalities, the challenge is to provide markets with the kind of assets that have low externality profiles and a structure which allows investors to easily fit them into portfolios, according to Sheren.

This effort – green securitisation – requires multilateral efforts and greater coordination across the industry. Large institutional credit investors are unlikely to buy debt unrated by credit rating agencies. For this transition to work, ratings agencies would have to expand the scope of their ratings to incorporate ESG considerations and externalities into their ratings process. Scaling up green assets will therefore require participation across the industry if we are to make the transition.

 

Michael appears in this podcast in his personal capacity. His commentary addressing capital markets and green securitisation reflects his G20 work and his own experience in sustainable finance. They do not necessarily reflect the views of the Bank of England.

 

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