Proposals to require banks in the EU to hold less capital against green lending have split opinion in the policy, banking and environmental activist communities. Could a small tweak to financial regulations unlock a green infrastructure investment boom or risk inflating a dangerous green bubble, posing a threat to banking stability and a collapse in confidence in low-carbon investments?

In January, the EU’s High Level Expert Group (HLEG) on Sustainable Finance issued a series of recommendations aimed at creating “a financial system that supports sustainable investments.” It reported “consistent feedback” from banks that the current capital framework, which dictates how much capital banks need to hold against their lending and investments to protect them against losses, requires them to hold greater reserves against “some traditional, non-complex lending operations and long-term exposures than is warranted by risk considerations.” The HLEG stated that it debated “the merits of lowering capital requirements for lending to the green sector.” It added that, as the report was being drawn up in December 2017, European Commission Vice-President Valdis Dombrovskis said the EU executive body was “looking positively at the European Parliament’s proposal to amend capital charges for banks to boost green investments and loans by introducing a so-called green supporting factor.” Dombrovskis suggested that a green supporting factor (GSF) could lower capital requirements for climate-friendly investments, such as energy-efficient mortgages or electric cars, and it could be modelled on existing capital requirement adjustments for investments in small and medium-sized enterprises (SMEs) or in high-quality infrastructure projects.

Regulatory relief

Such regulatory capital relief could make lending to green projects significantly cheaper and help tilt banks’ portfolios away from ”brown” investments, such as fossil fuel power plants and other high-carbon infrastructure. It is a prospect that has been welcomed by the banks themselves. Following the publication of the HLEG report, the French Banking Federation and the Italian Banking Association reiterated their earlier calls for a GSF. “This incentive mechanism, by reducing the capital charge on green funding, should speed up the channelling of climate investments and reduce climate risk on balance sheets,” the two associations said in a joint statement. Some are, however, sceptical about the usefulness — and wisdom — of a GSF. Frank van Lerven, an economist at the New Economics Foundation, a left-leaning think-tank, believes it would not have the desired effect of increasing lending. In a recent paper, he cites the introduction in January 2014 of an SME supporting factor, under the EU’s Capital Requirements Directive, designed to increase lending to smaller companies. A study of its impacts, published by the European Banking Authority in 2016, found “limited effectiveness.” It added, however, that “more data is needed before drawing conclusions.”

A threat to banking stability?

More seriously, he argues that a GSF could add to banking risks. “A Green Supporting Factor would make our financial system less stable,” he writes, because it could allow banks to build up large exposure to potentially risky green assets without adequate capital to protect them against losses. “Not only would it erode the hard work and progress that has been made towards stabilising our financial system, but it could also weaken an already fragile banking system.” In addition, if reckless lending to green projects led to the creation of a green bubble, its inevitable bursting and the subsequent losses to investors would “cause reputational damage to the field of sustainable finance which is still developing,” he adds. Sini Matikainen, a policy analyst with the Grantham Research Institute on Climate Change and the Environment in London, argues that a GSF should only be applied if it can be shown that green investments are less risky than brown ones. She notes that in the low-carbon transition there will be losers as well as winners. “And it’s not easy to predict who will be the winners.” “We would not advocate for a lower risk requirement unless it could be shown there was less risk,” agrees Alex White, acting policy manager at the Aldersgate Group, a business-led organisation advocating a sustainable economy. “There needs to be robust analysis of the different risk profiles of green and brown investments, but we believe that channelling investments into green infrastructure projects … underpinned by long-term contracts, should dramatically lower risk.” Indeed, the banking sector is beginning to make its own bets in that direction. In May 2018, the UK’s Lloyds Banking Group announced £2 billion in lending at discounted rates for businesses reducing their environmental impacts, increasing their energy efficiency or investing in low-carbon transport. The previous month, Barclays launched a green mortgage where buyers of more energy-efficient homes could borrow at lower rates. Certainly, some of those concerned about a GSF are more relaxed about raising the capital that banks should hold against high-carbon investments. “Rais[ing] risk weights for brown assets would strengthen banks and discourage lending for fossil fuel activities,” says advocacy group Finance Watch. “For society, if not for banks, a brown penalising factor is a win-win outcome.” However, while banks favour making lending cheaper for green borrowers, they are less keen on making it more expensive for clients involved in carbon-intensive parts of the economy. “Such a factor could negatively impact adequate risk management. Globally speaking there is no clarity about the definition of brown, while there is a lack of reliable data on the way that brown companies affect the climate,” says Wim Mijs, chief executive of the European Banking Federation.

Advancing the agenda

Sean Kidney, who runs the Climate Bonds Initiative, an investor-focused not-for-profit promoting green bond markets, and who was a member of the HLEG, describes himself as “a vocal supporter” of a GSF. But, as well as opposition from some green think tanks and NGOs, he says that the central bankers responsible for regulating the sector “aren’t supporters at all,” given their concerns over risk in the banking system. “However, the discussion around the capital weighting changes has served to advance the agenda. It’s been tremendously successful” in encouraging thinking about how monetary authorities and regulators can support green investment, he says. As examples, he cites a 1% discount China’s central bank applies to liquidity lending to its banks if they post green bonds as collateral and India’s consideration of a plan to add green lending to its regulated public sector lending requirements. In Europe, the European Central Bank is under pressure to include purchases of green bonds in its quantitative easing programme, he adds, while there is a proposal to include loans to renewable energy projects in the regulations governing Pfandbriefe, Germany’s €370 billion covered bond market. Kidney adds that there is “a reasonable chance” that Dombrovskis will bring forward proposals to amend the Capital Requirements Directive in favour of green investments. “A number of Members of the European Parliament are supportive.” But Kidney is agnostic as to whether what ultimately emerges is a GSF or an alternative. “The obligation is now on people who are poo-pooing capital ratio requirements to give us something better.”

Writer: Mark Nicholls