Oliver Schenker
Assistant Professor of Environmental Economics
Oliver is Robert Bosch Assistant Professor of Environmental Economics at Frankfurt School. In his re...
FS-UNEP Centre

The Tragedy of the Horizon: A Mandate for Financial Sector Regulations?

August 9, 2018
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Investment to the tune of around $6.3 trillion per annum in core infrastructure, energy efficiency and energy production is required globally over the next 15 years. Making these infrastructure investments consistent with the goal to limit global temperature increase to 2°C as stated in the Paris Agreement requires an additional $600 billion per year and a major change in the composition of investment towards zero or low-carbon assets, climate resilient sectors, and adaptation infrastructure. Meeting this demand remains a challenge since current investment levels in core infrastructure are only around $3.5 trillion. Many colleagues at Frankfurt School are working on this challenge, e.g., in the FS-UNEP Centre or at the Green and Sustainable Finance Cluster Germany, hosted by FS.

Renewable energy infrastructure is particularly capital intensive. Financing costs and interest payments can, e.g., account for around half of the total cost of electricity from a solar PV project. It is therefore crucial to think deeper about the determinants of capital costs and the efficient allocation of capital even under a functional carbon pricing scheme.

The tragedy of short-termism

Recently, both academics and policy makers started to debate the existence of financial market imperfections that challenge the efficient allocation of capital into low-carbon energy projects. One of these market imperfections has been famously termed by Mark Carney, the governor of the Bank of England, as the “tragedy of the horizon”: Investors, as well as regulators, would often be myopic, either because of behavioural reasons or because the incentive structures reward short-term performance. Moreover, investors might not be able to assess the relative risk of investments in high- versus low-carbon technologies due to incomplete information. As a result, they may not infer the ex-ante profitability of low carbon investment projects correctly or misprice carbon-related risk.

Some governments started to act and have already introduced regulations of the financial sector. France recently enacted Article 173 of an Energy Transition Law which mandates reporting and disclosure of climate-related risks of investments. The EU High-Level Expert Group (HLEG) on Sustainable Finance also recommends investment disclosure rules, a strengthening of the position of European supervisory agencies on sustainability, and developing official European standards on sustainable finance.

A Discussion with practitioners and academics

End of June, at the 6th World Congress of Environmental and Resource Economists in Gothenburg, Sweden, we, Ulf Moslener, Professor für Sustainable Energy Finance at Frankfurt School and Head of Research of the FS-UNEP Centre, Ashish Tyagi, Post-Doc at the FS Economics Department and I, organised a panel discussion to debate the severity of these market failures and their implications on government regulation. The panel convened regulators, private sector actors and academics: Mats Andersson, former CEO of the Fourth Swedish National Pension Fund (AP4); Dirk Schoenmaker, Professor of Banking and Finance at the Rotterdam School of Management; Sandra Batten, Senior Economist at the Bank of England, and Ulf. I had the pleasure to moderate the discussion.

Tools rather than rules

The panellists highlighted the need for “tools rather than rules”. Data on company’s environmental footprint such as in various environmental, social and governance (ESG) indices or disclosure requirements as in the French financial market regulation are important in providing information to investors to correctly assess relative profitability and risks across different technologies, companies and sectors. Transparency induced by more forward-looking information revealing, e.g., actions by the management in order to position the firm within the structural change towards a low or no-carbon economy can help investors to assess the consistency of businesses with long-term climate goals. More intrusive regulation like government classification of assets were seen by some to increase the risk of delay if much time is spent discussing fundamentals and firms may feel incentivized to wait for decisions, e.g., on an official taxonomy.

But the panellists also highlighted the necessary change in values. Investors would need to behave more like owners. It is in the owner’s interest to improve ESG rating as there is evidence linking better ESG ratings with better valuation and long-term performance of companies.

The risk of being behind the curve

As both, Dirk Schoenmaker and Mats Andersson pointed out, this is possible because already relatively small portfolios are able to diversify risk sufficiently. Thus, fund managers and investors can actually look at “companies rather than portfolios” in order to make their investment decision. As discussed in our panel (and also here), among 10 major sectors from 1925 to 2017, the difference in annualized returns between the best and the worst sector was just 54 basis points. Decarbonizing your portfolio by excluding fossil fuel companies or other major polluters is unlikely to jeopardize long-term prospects but reduces the long-term climate risks of a portfolio.

In conclusion, given the pressing demands for infrastructure investment and energy transition, an efficient flow of capital towards low-carbon sectors is necessary to reduce global warming below 2°C. Financial market imperfections can create barriers to an efficient capital allocation. Regulation that makes more information available to investors can be helpful but we need to be cautious with more intrusive regulation that will likely be “behind the curve” and ineffective. In the view of the panel, availability and better use of information to create tools such as ESG indices, a proactive role of owners can reduce these market imperfections.

Written by Ulf Moslener, Ashish Tyagi and Oliver Schenker

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