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Capital Markets Weekly: Sweden selling assets on environmental grounds following sizable Norwegian divestitures

19 November 2019 Brian Lawson

In a statement on 13 November, Martin Flodén, the Deputy Governor of Sweden's Riksbank, the country's central bank, announced that it had sold its holdings in bonds issued by the Canadian Province of Alberta and the Australian States of Queensland and Western Australia. The move was taken to reflect a decision by the Riksbank's Executive Board to base its investments on sustainability criteria.

He was quoted by Reuters as having stated that "Australia and Canada are countries that are not known for good climate work", having among the world's highest per capital carbon emissions. However, Flodén noted that its investments "are largely in bonds issued by central and federal governments" reducing its scope to refocus its investments towards Green Bonds. Flodén stated that Sweden had invested roughly 8% of its foreign exchange reserves in Australian and Canadian debt, without specifying how much was held in the affected areas.

Sweden's move was strongly criticized by Christine Myatt, spokesperson for Albertan Premier Jason Kelly, who argued that if the Riksbank were "really concerned with making a difference on climate change", it should be "investing more in ethical producers such as Alberta which have shown dramatic gains in reducing emissions".

Sweden's move follows a larger asset shift in Norway. In June 2019, the Norwegian parliament approved a plan for its Government Pension Fund Global, its USD1 trillion wealth fund from the country's past energy earnings, to divest USD13 billion of investments in carbon-intensive sectors. These were reported at the time to cover holdings in eight coal firms worth an estimated USD6 billion and roughly 150 oil producers.

Going forward it plans to avoid the assets of any firm that generates more than 10GW of electricity annually from coal or mines over 20 million tons of thermal coal. The legislation also granted it powers to invest up to USD20 billion directly in renewable energy projects (rather than its prior focus on listed companies) with a focus on wind and solar energy projects.

In October, the country's Finance Ministry issued a further statement that under the prior approval it would divest its holdings in oil explorers but retain its downstream exposures and positions in integrated oil majors. The decision will thus impact 95 companies in positions worth USD5.92 billion. While representing sizeable changes, Norway has scaled back its disposal plans substantially from the initial suggestions submitted by the government in 2017: originally these had considered divesting USD37 billion of assets, including all its oil-sector exposures.

Implications and outlook

While still relatively isolated, the latest developments highlight the growing sensitivity of global investment flows to environmental and social issues. Regulatory attention is also likely to increase.

Capital market focus

Environmentally-sensitive investment is growing. In last week's Capital Markets Weekly, we noted that according to a Moody's report, Green Bond issue volumes reached USD189.5 billion in the first three quarters of 2019, surpassing the 2018 full-year total of USD171.1 billion.

We have also noted in our weekly Capital Markets reports that use of green and other environmental or social structures increasingly appear to achieve tangible cost benefits for borrowers, reflecting the deeper investor base available and incremental demand from ESG funds. We also have commented how obtaining equity finance for coal companies - even those with the best technology and least damaging environmental footprint - is becoming more difficult, as investors show greater sensitivity to the environmental implications of their investments.

Over a longer time-span, BlackRock projected in 2018, when announcing plans to enable its investors "to align their investments with their values", that sustainable exchange traded funds would grow in volume from USD25 billion at the time to USD400 billion by 2028, with the share of ESG funds rising from 3% to 21% by 2028.

Reflecting these trends, Euronext - which owns six European stock exchanges - recently pledged that its strategy for the next three years would focus on developing the market for Green bonds and in establishing indices for ESG-focused instruments.

These risks go beyond banking sector exposures to impact all categories of investor. Bank of England Governor Mark Carney has warned several times - most recently in a mid-October interview with the UK Guardian newspaper - that companies that lag in adapting to climate-related issues will "be punished": in his view, those that fail to change direction "will go bankrupt without question", potentially undermining the value of existing investments and "stranding" carbon-intensive projects. The associated downside risks thus span all categories of investor.

In prior analysis the Bank of England identified USD20 trillion of assets as being at risk, suggesting that the worst-case risk would be a sudden sharp downward shift in their value alongside major damage to the financial system through defaults on bank exposures. Counter-balancing this, Carney also has flagged that sizeable new opportunities exist for those firms active in reducing carbon emissions and developing new technologies.

Regulatory focus

Global regulators and governments also are increasingly concerned about climate risk as requiring a regulatory response for its threats to global financial stability, as evidenced by multiple recent statements.

In April 2019, 34 central banks worldwide under the umbrella of the "Network for Greening the Financial System" (NGFS) published a joint letter recommending integrating climate risks into bank supervision given its growing yet currently-unquantifiable financial risks.

In May 2019, an ECB analysis in its Financial Stability Review identified these as:

  • The growing frequency of weather-related catastrophic events impacting credit risk, with direct impacts on real-economy assets to which banks are exposed.
  • Transition risks, including the risk of "stranded assets", exposures that could face "abrupt asset price decreases" given changing environmental policies, and increasing default risks. While data reporting was not comprehensive, the study flagged EUR720 billion - or 3% of Euro-area banks' total assets - as exposed to climate-sensitive assets.

In May 2019, Bank of Canada produced its first report on threats to financial stability from climate change. It designated climate change as one of six key risks faced by the country's financial system, citing both physical risks from disruptive weather events and transition risks.

Bank of Canada plans a multi-year research plan to "better assess the risks" and how this impacts its mandate. It noted that insured extreme weather damage averaged about CAD1.7 billion in the period 2008-17, versus CAD200 million between 1983-2002, with Canada particularly at risk as "it is estimated to be warming significantly faster than the rest of the world". To improve understanding of such risks, it backed the Financial Stability Board's recommendation, through its Climate Change Task Force, that companies should disclose information relating to their climate impact and the financial consequences this might have.

Its stance was reinforced by the country's latest Financial System Survey. Published on 14 November, it obtained feedback from 47 respondents in the Canadian financial system, covering climate change for the first time. 67.5% of those surveyed viewed decreases in the value of assets as the main channel for physical risk. 80% felt they faced reputational damage from transition risk, 66.67% feared increased expenses and 65% were concerned by the prospect of portfolio losses.

Despite the multiple indicators of growing regulatory concern, this is certainly not uniform. In particular, the US stance is clearly unaligned with that of Canada. In testimony to the Joint Economic Committee of Congress on 13 November, Federal Reserve Chair Jay Powell stated that while "climate change is an important issue", it was one that was "assigned to lots of other government agencies" and as such was "not principally for the Fed". His comments came despite the San Francisco Federal Reserve recently holding its first conference on climate change and a comment on 8 November by Fed Governor Lael Brainard stated that "it will be important" for the Fed to study its impact.

Overall, as governments alter their policy stances, IHS Markit expects greater regulatory focus on such risks, even if this is not uniform. The moves by Sweden and Norway already indicate increasing risks of price underperformance and higher funding costs for companies deemed to have adverse environmental footprints. If more governments and investors adopt a similar approach, price implications for those affected - both adversely and positively - would be likely to increase over time.

Indicators of risk increasing

  • Withdrawal and downsizing of equity and debt issues particularly affecting companies in coal but extending to the oil and gas and power generation sectors.
  • Further announcements involving major central banks, sovereign wealth funds and asset managers looking to exit or reduce existing carbon-intensive exposures.
  • Further expansion of ESG funds: Morningstar data shows that sustainable mutual funds have grown 80% in number to 3955 since 2012, with assets managed reaching USD1.8 trillion, a near-doubling.
  • Announcement of new regulatory initiatives affecting banks with sizeable carbon-intensive exposures, such as imposing increased mandatory risk weighted capital requirements for such exposures.

Indicators of risk declining

  • Application of extended portfolio adjustment periods by investors deciding to exit specific categories of asset, limiting price impacts.
  • Pre-emptive moves by banks to address environmental risks by internal controls, such as application of higher internal capital charges or self-imposed limits, limiting the threat of financial dislocations and the impact of any future regulatory changes.
  • Moves by key energy majors to diversify into new technologies and support renewable development, reducing the risk of blanket investor bans and increasing the likelihood that existing holdings are retained (as in Norway).
  • More statements by key financial regulators passing responsibility to other agencies, as recently suggested by US Federal reserve Chair Jay Powell.

Posted 19 November 2019 by Brian Lawson, Senior Economic and Financial Consultant, Country Risk, IHS Markit

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