The Greening of Markets

• Author: Paul Mills
• Position: Senior Economist in the IMF's Monetary and Capital Markets Department
• Pages: 32-36

Page 32

Financial markets can play a valuable role in addressing climate change

IT Is not immediately obvious what role financial markets can play in addressing climate change. Climate change happens slowly and has a global impact on the physical environment, whereas financial markets react to news in fractions of a second and are almost liberated from specific physical locations. the low energy intensity of the financial sector means that reductions in greenhouse gas (GHG) emissions would have little impact on the physical operations of financial markets and institutions (unlike, for instance, their effects on electricity production or transport).

Nevertheless, financial markets potentially play two important roles in the policy response to climate change (see table). First, they foster mitigation strategies-that is, the steps taken to reduce GHG emissions for a given level of economic activity-by improving the efficiency of schemes to price and reduce emissions (for example, carbon permit trading) and the allocation of capital to cleaner technologies and producers. second, financial markets can cut the costs of adaptation-that is, how economies respond to climate change-by reallocating capital to newly productive sectors and regions and hedging weather-related risks.

In recent years, markets in carbon permit trading, weather derivatives, and catastrophe (CAt) bonds have seen sharp increases in activity and innovation, which bodes well for the future. But if a basic understanding of finance is not reflected in policy design, climate change policy can suffer setbacks. Hence, recognizing how financial markets will react to climate change initiatives, and how they can best promote mitigation and adaptation, will become crucial to shaping future policy and minimizing its costs.

Reducing GHG emissions

On the mitigation front, a large number of countries have committed, or are likely to commit, to targets to curb GHG emissions by 2012 under the Kyoto Protocol or its successor arrangement. In addition to regulatory restrictions, this policy goal can be achieved through either emissions taxes or schemes to cap emissions and allow trading of permits. In such an environment, financial markets can reinforce commercial pressures on firms to reduce emissions.

Identifying the right tools

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One such mechanism is the "green" investment fund. Originally part of the movement for "socially responsible" or "ethical" investment, such funds were established in the 1980s to invest only in companies working to limit the environmental damage they caused. since then, more specialist funds have been launched that invest in companies, projects, and technologies involved in reducing GHG emissions. In fact, some recently launched equity indices comprise only shares of companies that have low GHG emissions or are investing in abatement technologies. the amounts invested in green funds are as yet too small to have a significant impact on overall equity performance. But if the post-Kyoto settlement results in a sig-Page 33nificant tax on, or price for, GHG emissions, then companies with low current emissions or investments in abatement technologies should outperform the market. Indeed, this already seems to have been anticipated by equity investors. When launched in October 2007, the 300 stocks comprising the HsBC Global Climate Change Index had outperformed the MsCI World Index by 70 percent since 2004.

More generally, as GHG emissions are taxed or rationed, to the extent that companies are unable fully to pass on these costs, the cost of capital for heavy emitters will suffer relative to their competitors. such price signals will reallocate capacity to sectors and regions in which production, investment, and research are most profitable, given a higher price for emitting GHGs.

A second mechanism is the Kyoto Protocol's Clean Development Mechanism (CDM), which allows cheaper emissions reductions in emerging markets and low-income countries to be certified by the UN and then sold as credits to offset emissions in cap-and-trade schemes in high-income countries...