Green / Sustainable Finance + Climate Risk Flashcards
Place “green finance” within “sustainable finance”
Green finance means the subset of all finance instruments with environmental goals, with the following themes nested:
- – Climate Change Mitigation (low carbon)
- Climate Change Adaption (climate-related)
- Other Environmental
Sustainable Finance also includes Social, Economic, and Governance Themes.
Distinguish between “targeted” green financing and “untargeted” green financing
TARGETED GREEN FINANCING:
Capital is provided for the development and implementation of green technologies / activities / projects (such as the construction of photovoltaic solar electricity generation facilities) or for companies whose revenues are generated to a high extent by green technologies / activities (“specialist green companies”).
UNTARGETED GREEN FINANCING:
Capital is provided for companies that successfully manage environmental (as well as social and governance (ESG)) risks and are thus perceived as more environmentally friendly than others.
What are green bonds?
According to the Green Bond Principles (GBP), “green bonds are any type of bond instrument where the proceeds will be exclusively applied to finance or re-finance new or existing eligible green projects”. In order for a bond to be labelled and accepted as “green”, it is, therefore, required to specify how the proceeds of a bond will be used.
Many green bond issuers develop their own green bond frameworks, e.g. Nordic Investment Bank, Renovate America, Asian Development Bank.
The European Investment Bank (EIB) also leads the effort for a “descriptive” or “standard-neutral” taxonomy.
What are “green activities” in equity investing?
- Screening by ESG criteria
- ESG integration into investment appraisal
- Corporate engagement and shareholder action
- Sustainability themed investing (e.g. green tech)
- Impact investing
Describe the EU Sustainable Finance Taxonomy’s criteria for “identifying ESG”
To be eligible, an economic activity must make substantial contribution to at least one or more of the six environmental objectives, and does no significant harm to the other five, and meets the requirements of the minimum Social Safeguards.
Six environmental objectives:
1: climate change mitigation
2: climate change adaptation
3: sustainable use and protection of water and marine resources
4: transition to a circular economy, waste prevention and recycling
5: pollution prevention and control
6: protection of healthy ecosystems.
How does the EU Sustainable Finance Taxonomy support the “brown-to-green” transition?
The taxonomy covers some economic sectors and activities that are currently not green or low carbon, but are believed to be low carbon in future, or will make substantial contribution to climate change with policy incentives.
However, these activities must improve their performance significantly to reach a level above the industry average. This is to avoid the carbon lock-in effect of carbon intensive assets or process.
Describe the 3 main policy taxonomies for green investment
EU Sustainable Finance Taxonomy:
- Goal: Paris Agreements, climate/environment policies
- Users: Financial market
- Classification: NACE code
- Screening: ESG Principles, carbon thremission thresholds, exclude fossil fuels
NDRC Green Industry Catalogue:
- Goal: Pollution prevention, green industry development
- Users: Policymakers
- Classification: none
- Screening: none
PBC Green Project Endorsed Catalogue:
- Goal: Robust green bond market, 6 environmental objectives
- Users: Green bond issuers
- Classification: industry codes
- Screening: none
Define “green finance”
Green finance is a type of future-oriented finance that simultaneously pursues the development of financial industry, improvement of the environment, and economic growth.
“Green finance should incorporate new technologies, financial products, industries, and services that consider environment, energy efficiency, and reduction of pollutant emissions to support low-carbon green growth”
Define “Sustainable Finance”
Sustainable Finance is the practice of creating economic and social value through financial models, products, and markets that are sustainable over time
Define “Environmental Finance”
Environmental Finance is finance and investment regarding the ecological environment (Air, water, soil, etc.) Environmental Finance regards environmental damage as financial risk. Under environmental finance, projects that harm or potentially damage the environment are prohibited from being funded or financed. This concept is broader than Green Finance in that it focuses on environmental protection, which may not contribute to economic growth.
Define “carbon finance”
Carbon Finance provides resources to a project which aims to reduce emissions of carbon dioxide and other GHGs
Define “climate finance”
Climate finance supports the activities of climate change adaptation and mitigation to achieve low-carbon economy and implement climate resilient development
Describe the sustainability-linked loan principles
- Relationship to the borrower’s overall CSR strategy
- Target setting – measuring the sustainability of the borrower
- Reporting: borrower to make and keep readily available up to date information relating to its SPTs.
- Review: For each transaction the need for external review is to be negotiated and agreed between the borrower and lenders.
Describe the [green loan / green bond / social bond] principles
- Use of Proceeds:
the proceeds of the loan are used to finance “green projects” as described in the GLP - Project Evaluation/Selection:
the borrower has developed a process for green project evaluation and selection - Monitoring:
the borrower manages and tracks the use of the loan proceeds, and - Reporting:
the borrower makes and keeps available up-to-date information on the use of proceeds.
What is a synthetic ABS bond structure?
In a synthetic ABS (Asset-Backed Security), the issuing bank retains ownership of the loans it wants to use as collateral for the deal but transfers the associated credit risk to an investor via the ABS structure.
What is a MTN bond structure?
Medium term note (MTN) programmes create a debt issuance framework which gives the issuer the flexibility to come to market repeatedly to raise funding.
The eligibility criteria are fixed, but bond terms are set for each bond issue.
What is a green Sukuk bond structure?
A sukuk is an Islamic financial instrument, that complies with Sharia law. The issuer sells an investor group certificates, uses the proceeds to purchase an asset, of which the investor group has partial ownership, and distributes part of the asset revenues as profit to the investors. The assets need to comply with Islamic ethical values, which include green assets and projects.
What is a perpetual bond?
Perpetuals are bonds without a maturity date, i.e. they remain outstanding in perpetuity. However, issuers set call dates when they can redeem the bonds and these are typically 5-7 years after bond issuance.
What are Schuldschein bonds?
Schuldschein or SSD (SchuldScheinDarlehen), also referred to as certificate of indebtedness, are privately placed, unlisted, bilateral loan notes. The debt is legally constituted by the underlying loan agreement, so the instrument is treated as a loan by investors.
What is a private placement bond?
In private placements, the bond issuer places the bond directly with the investor. Certain terms such as the tenor or currency may be chosen to match investor preferences. Private placement (PP) bonds are typically not listed.
What are US Munis?
US Municipal bonds benefit from favourable tax treatment to facilitate access to private funding for public sector spending, including infrastructure investments. They feature long tenors and are often sold as a pension investment.
What are PACE ABS?
The US Property Assessed Clean Energy (PACE) model is an innovative mechanism for financing energy efficiency and renewable energy improvements. PACE loans fund the upfront cost of energy improvements on residential and commercial properties, and are paid back over time by property owners through property tax bills.
What are solar ABS?
Solar Asset-Backed-Securities (ABS) are securitisations secured on cash flows from solar assets
What are Agency MBS?
US government agencies Fannie Mae and Freddie Mac purchase a significant volume of mortgage pools from originating lenders and refinance them in the mortgage-backed securities (MBS) market.
What are RMBS?
Residential mortgage-backed securities (RMBS) are ABS deals secured on large pools of residential mortgages.
What are CMBS?
Commercial mortgage-backed securities (CMBS) are ABS deals secured on commercial mortgages.
What are Covered Bonds?
Covered bonds are highly-regulated securities
with superior credit ratings. They achieve lower funding cost than unsecured debt thanks to a dual recourse structure where bond investors have a general claim against the issuer, as well as a claim over a dedicated ‘cover’ pool of assets. Cover pool composition is regularly monitored.
What are receivables ABS?
Any stream of receivables or revenues can be used to secure an ABS deal as long as the revenue is predict-able enough to be modelled and valued
What are the main types of external review for a [green loan / green bond / social bond]?
- Second party opinion
- Verification
- Certification
- Green Bond Scoring/Rating
What are the PRA’s expectations for the management of climate-driven financial risks?
- Governance, including Risk Appetite Statement (RA)
- Risk management
- Scenario analysis
- Disclosure
What are the core elements of the climate-related financial disclosures recommended by the TCFD (Task Force on Climate-related Financial Disclosures)?
- Governance
- Strategy
- – Risk management
- — Metrics and targets
How Do Climate Risks Translate into Credit Risks? (3 Dimensions, and 3 Parts of Scenario Building)
Dimensions:
- Climate Risks to Cash Flows
- Climate Risks to Financial Wealth
- Climate Risks to Value of the Collateral
Scenario Building
- Defining Climate Scenarios
- Estimating economic and financial impacts
- Translating financial impacts into credit risk measures
What are the 5 methodological challenges to estimating credit risk impact of climate change?
1) addressing the limitations of historical data
2) expanding the horizon of credit risk models
3) finding the right level of data granularity
4) identifying the relevant climate risk exposure metrics
5) translating economic impact into financial risk metrics
What are the key choices for defining physical climate risk scenarios?
1) which type of climate-related hazards are modelled
2) which regions are studied
3) which regional granularity is used
4) which climate change severity and trajectory is assumed
What are the key choices for defining transition climate risk scenarios?
1) what is the level of ambition in terms of emission reduction and limiting global warming
2) what is its speed
3) what are the drivers of the transition (policy/tech/preference change)
What are the 3 main components of systemic financial risk due to climate change?
- That exposures of financial institutions to carbon-intensive sectors are large relative to overall assets
- That the impact of policy and technology is not already being priced into the market, either through lower expected returns or higher risk premiums
- That any subsequent correction would not allow financial institutions to adjust their portfolios in an orderly manner
What are the main exposures to carbon asset risks at the sector level?
- Fossil assets
- Fossil-fuel dependent infrastructure or activities
- High-carbon assets facing shift to low-carbon assets
- High-carbon assets without low-carbon competitors
Describe the structure of the Carbon Asset Risk (CAR) Assessment Framework
I) Asset Exposure
- Carbon Risk Factors
- policy/legal
- tech
- market/economic
- reputational
- Exposure to Carbon Risks
- Physical assets
- Operators
- Financial assets
- Financial portfolios
II) Evaluate Risk
- Screening
- Operator: Stress test and valuation (NPV/IRR/Break-even)
- Portfolio: Stress test and risk models
III) Manage Risk
- Avoidance/divestment of sector/security
- Active risk management
- Risk disclosure
- Sectoral policies
- Due diligence / risk pricing
- Diversification
- Engagement
What is the link between climate change and fiduciary duty?
Fiduciary duty bestows a requirement upon all trustees to consider current and evolving risks when making investment decisions. Insofar as climate change carries material financial risks, trustees will need to consider it as a core part of fiduciary duty
What are the MSCI ESG Issues and Themes?
I) ENVIRONMENT
- Climate change
- Natural resources
- Pollution and waste
- Environmental opportunities
II) SOCIAL
- Human capital
- Product liability / safety
- Stakeholder opposition
- Social opportunities
III) GOVERNANCE
- Corporate governance
- Corporate behaviour
What are liability issues in I) complying and II) not complying with the TCFD recommendations?
I) Liability Issues From Complying (disproven)
- Imprecise stress-testing and scenario analysis
- Violating reporting obligations by reporting climate risk
- Violating disclosure laws through forward-looking statements
II) Liability Issues From Not complying
- Director’s duties include climate risk as foreseeable financial risk issue
- Ignoring likely future developments
Describe the TCFD climate-related risk types for companies
TCFD (Task Force on Climate-Related Financial Disclosures) climate risk types:
I) Physical risks
- Acute risks
- Chronic risks
II) Transition-related risks
- Policy and legal risks
- Technology risks
- Market risks
- Reputation risks
Describe the TCFD climate-related opportunities for companies
- Resource efficiency
- New energy sources
- New products and service
- Markets / assets / public sector incentives
- Increased resilience
Describe the TCFD’s 3 common climate-related risk metrics
1: Weighted average carbon intensity
2: Carbon footprint
3: Carbon intensity
(see page 528 for formulae)
