The financial sector, heavily regulated to ensure stability, faces challenges in supporting the low-carbon transition. Regulations designed to prevent crises and provide credible asset valuations may inadvertently favor fossil fuel investments. Research conducted by a team of experts using data from European banks reveals a structural bias in financial models that assess and report risk, which could hinder the green transition.
Financial models traditionally rely on historical data to gauge firms’ creditworthiness. Alarmingly, these models view carbon-intensive assets as less risky compared to lower-carbon alternatives. This discrepancy results in higher interest rates for renewable energy projects, making them more expensive to finance. As a result, banks may be discouraged from divesting high-carbon assets in favor of green investments, slowing the transition to a sustainable economy.
A detailed analysis of European Banking Authority (EBA) data highlights significant differences in risk assessments for high-carbon and low-carbon sectors. The average risk estimate for high-carbon sectors is 1.8%, compared to 3.4% for low-carbon sectors. This variance directly impacts banks’ profitability and their lending decisions, creating incentives to favor high-carbon investments over greener alternatives.
One of the largest barriers to generating renewable energy is the upfront cost of raising investment. Financial regulations that categorize renewable energy projects as high-risk lead to higher interest rates, increasing the cost of constructing wind and solar farms. Conversely, the lower risk estimates for high-carbon activities make them more attractive to banks, perpetuating their investment in fossil fuels.
Financial models that rely on historical trends may not accurately reflect the evolving landscape of renewable energy. As the cost of generating renewable energy decreases, these models may overestimate the risks associated with low-carbon investments. Capital requirement regulations, like Basel III/IV, also use similar backward-looking models, influencing economic incentives and financial behavior.
Forward-looking models incorporating climate scenarios could be employed to better align financial risk assessments with the goals of the low-carbon transition. These models would provide a more accurate projection of risks associated with high-carbon investments and help remove biases against green investments. Policymakers and financial regulators must recognize the need for updated tools and regulations that support the net-zero carbon transition.
