In 2015, the global leaders gathered in Paris acknowledged that climate change represents an urgent and potentially irreversible threat to human societies and the planet, and agreed to work together to limit global warming well below 2°C. Achieving this goal requires global investment to shift away from fossil fuel extraction and power generation towards developing low-carbon energy sources and increasing energy efficiency in the coming years. Retail investors could play a big part in this process if more ‘green’ financial products are marketed on online investment platforms that make it easy for people to understand, assess and compare the climate-related risks in alternative products.
Meeting the 2°C goal requires a meaningful reduction in greenhouse gas emissions, such as carbon dioxide (CO2). If investors are currently not fully pricing in the economic transition needed to achieve the 2°C goal, investments in fossil fuel extraction and infrastructure (e.g. coal fired power plants) could be less profitable than expected when climate policies are eventually tightened. Conversely, some of the potentially profitable investment opportunities in low-carbon alternatives may be overlooked. In this context, the work by the Financial Stability Board (FSB)’s Task Force on Climate-related Financial Disclosures, which suggested concrete ways for companies to voluntarily disclose more information on climate-related risks and opportunities that can impact their financial performance, is a welcome step towards increasing the quality and quantity of information available to investors. Importantly, the recommendations also apply to financial sector organisations such as banks, insurance companies, asset managers and asset owners. It is hoped that better information will encourage investors to take into account climate-related risks and opportunities in their decisions. That in turn could help prevent inefficient investments and reduce the risk of disorderly asset price adjustments, and thereby support financial stability during the period of transition towards a low-carbon economy.
Climate-related financial disclosures could potentially have a big impact if they inform the decisions of a wide range of investors. Institutional investors are important, but retail investors do matter, too. For instance, Mrs Watanabe – the archetypical Japanese housewife (or retail) yen carry trader – has been a big player in the FX market for some time, but her investment decisions might also shape the future economy, as she’s reportedly been pouring money into robots more recently. BCG estimates that, of the US$71.4 trillion of assets under management globally at end-2015, 40% were retail, and that this segment has been growing relative to the institutional segment. And retail interest in sustainable investment is increasing: the global sustainable investment market is estimated to have grown to US$22.9 trillion at the start of 2016, up 25% from 2014, while the share of retail assets in total sustainable investment in Canada, Europe and the United States is estimated to have increased from 13% to 26% during the same period. This trend may well continue, as apparently millennials are particularly interested in sustainable investing. So the climate-related financial disclosures could have a major impact on the global investment patterns in the coming years, if they inform the decisions of retail investors as well as the decisions of more sophisticated institutional investors.
But for retail investors, the way financial institutions implement the FSB’s disclosure recommendations may matter a lot. Unless the information on climate-related financial risks in different financial products are easy to find (e.g. on online investment platforms), easy to compare against each other, and easy to act on (e.g. just by a mouse click), retail investors may not pay attention to such information. I, for instance, happen to have done some work on the impact of climate change on central banks recently, and in the process I have learned enough facts to understand that meeting the 2°C goal requires resolute action to curb global CO2 emission from now on. But will the climate-related financial disclosures affect my own investment decisions? I’d like to say yes, but a more honest answer is that I will need some help here. I’m a busy working mum with two young kids and an even busier husband, so my free time in a normal working week averages around 30 minutes per day. I never read company reports in my spare time, and unlike Leonardo di Caprio, I don’t think I can hire my own wealth manager or financial adviser to read them for me and decipher newly available information on climate-related financial risks, either. But if the newly available information on climate-related financial risks is presented in a sufficiently simple, user-friendly format, I can take into account these risks in my investment decisions.
There are many instances in which it is the simplified information that influences my choice, rather than the more detailed information. For instance, when I go shopping for food in a supermarket, I do look at the food traffic lights – which shows whether an item contains too much fat, sugar or salt. But I hardly ever stand in the aisle to carefully study the list of ingredients at the back of the product. Why? Because the food traffic lights help me to digest the most essential nutritional information quickly, and allows me to compare alternative products easily against the same metric. Admittedly, when I go to an online fund supermarket to pick a fund to invest in, I do a bit more work to study the charts for past performances, the ratings, the composition, etc. But in going through this process, I’m more likely to pay attention to the information on climate-related financial risks if it is presented as simply and prominently as the food traffic lights – for example something like what’s below – than if it is given in several paragraphs of text and numbers that I can’t easily make sense of. Simplified information akin to the food traffic lights would make it much easier to compare alternative investment products against each other, too.
It would also help if acting on the information is made more hassle free, for example in re-allocating the existing stock of investment. I recently managed to pick up (in my precious spare time) an interesting book by David Halpern, Inside the Nudge Unit. One policy experiment discussed in the book is a case of getting Londoners to insulate their lofts: uninsulated roofs apparently account for 25% of heat loss from a house. So they offered two alternative incentive schemes to help people to get their act together:
Scheme 1: a substantial discount on home insulation service if a neighbour booked the service at the same time; and
Scheme 2: a home insulation service combined with a loft clearing service, at a significant extra cost to insulation alone.
They found that, compared with the standard offer, the discount (Scheme 1) did not lead to a statistically significant increase in the uptake, while combining the offer with a loft clearing service (Scheme 2) led to a three-fold increase in the uptake, despite the extra cost.
I think there is something to be learned from this experiment. For many retail investors, reviewing the existing asset portfolio and doing research to re-allocate it is simply a bother, much like clearing up the loft. But most of us probably know that we should do this once in a while, and so might be tempted to do it if it was made easy enough for us. For instance, I would do it if there was an online platform in which, with a click of a button, I can get a list of alternative financial products that are less exposed to climate-related risks, but are otherwise similar to my existing portfolios, and with another click of a button, I can just switch my portfolio at a minimal transaction cost. You can find my amateur attempt to design such an interface below.
So improving disclosures on climate-related financial risks is a much needed first step, but the way financial institutions present the disclosed information is likely to have a major impact on how retail investors react to it. Taking into account climate-related financial risks in investment decisions could become more ‘mainstream’ if financial institutions use the newly available information to develop user-friendly financial products and design online platforms that enable people to easily sort, evaluate and compare the risks in alternative products. It may take some time for a mass market to develop in this space, but once it takes off, it has the potential for triggering a powerful virtuous cycle: as more investors start paying attention to information on climate-related financial risks, more companies will be compelled to disclose more and better information, and the resulting investor discipline can in turn influence companies’ investment strategies. Once unleashed, such a force might even trump any near-term wobbles in climate policies and help prevent new investments in sectors that will be at risk of losing value in the 2°C scenarios, while boosting the market for green finance. Ultimately, such a force could pave the way for an orderly transition to a low-carbon economy.
Misa Tanaka works in the Bank’s Research Hub.
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Bank Underground is a blog for Bank of England staff to share views that challenge – or support – prevailing policy orthodoxies. The views expressed here are those of the authors, and are not necessarily those of the Bank of England, or its policy committees.