Banking and finance are unlikely to be major contributors to carbon emissions in the same way as basic industries or transport. But, as the UK Government has noted, achieving net zero will need ambitious action in all sectors of the economy.
The physical parts and activities of finance, banking, and payments have a direct effect on emissions and will need to adapt to the requirements of meeting net zero, rather than leaving action to other sectors. More importantly, however, banking and finance has a crucial role to play in allocating capital and investment if climate change is to be addressed.
Increased flows of finance to low carbon and sustainable technologies and initiatives and reduced flows to high carbon and less sustainable technologies and initiatives will have a significant impact on the speed and effectiveness of climate action. Achieving this transition often requires the right fiscal and broader government policies and incentives to support the investment case. In addition, industry participants are likely to need to work together; to standardise their use of terms; and to provide greater transparency about the impact of climate and transition risk on their loan portfolios and business models.
But might greater cooperation and standardisation risk some reduction in the range of products offered and in the intensity of competition both in the provision of financial services and between those companies seeking finance?
This Insight article identifies areas where competition concerns could arise as the finance industry responds to the risks of climate change. However, the authors are not saying that such concerns should preclude action on climate change. Rather, we have identified where these risks could arise so that they can be managed effectively.
These impacts may emerge in two ways: firstly in the establishment of green finance standards; and secondly in the sphere of financial disclosure related to environmental issues.
Although we identify potential competition concerns which may arise, we believe that it is possible both to increase the consistency and transparency of Environmental, Social and Governance (ESG) definitions and to improve the quality of financial disclosures in this area in a way that is compatible with competition law. Competition law should not be a barrier to progress.
Banking and the environment – direct impacts
One obvious direct contribution of banking and finance to emissions is the physical distribution of cash and coin throughout the economy (though that will reduce over time as usage diminishes). A 2018 study by the Central Bank of the Netherlands looked at the environmental impact of the Dutch cash payment system and debit card payment chain. It found that:
- Cash transport had the largest environmental impact, with copper ore extraction (for coin production) and ATM power consumption also significant.
- In the debit card payment chain, point-of-sale terminals had the largest environmental impact, followed by debit card payment processing centres and plastic card production.
The study proposed several changes, such as reducing ATM numbers and transporting cash using hybrid trucks.
The Bank of England (BoE) has similarly considered carbon emissions generated by the cash system and made various improvements, such as introducing polymer £5 and £10 notes. Still, as identified by the Dutch study, there remain several other emission-cutting measures that could be applied.
A recent report commissioned by LINK examines the carbon footprint of UK cash distribution and makes recommendations for how this footprint can be reduced. In addition, a UK cash industry charter has been announced, committing signatories to reduce single-use plastic, move quickly to renewable energy, and achieve net zero in operations by 2030.
The balance between maintaining access to resources such as physical cash for those who depend on it, and addressing its direct effects on the environment, is representative of the conflict faced by the banking and finance sector more broadly. How can the industry strike a balance between creating a competitive, innovative market that meets consumer needs, and a financial system that reduces its harmful impact on the environment?
Banking and the environment – indirect impacts
The indirect impact of banking and finance on the environment is significant. One report found that 33 global banks have financed fossil fuels with $1.9 trillion since the Paris Agreement was adopted (2016–2018), and that this amount has risen each year. At the same time, €6.2 trillion of investment will be required by 2030 to limit global warming to 2° Celsius. Some of this will come from public sources, but the transition to a low-carbon economy requires substantial investment, which realistically can only be financed with private sector involvement.
The financial sector also plays a key role in pricing the risks of climate change, and in transmitting the pricing effects should these risks crystallise. Both physical and transitional risks of climate change may impact on the position of financial firms. Damage to homes and businesses from climate change, including storm impacts, may increase the risk of defaults on loans and the viability of insurance products. Similarly, the transition to a more sustainable economy is likely to entail significant changes in asset prices in response to changes in technology, policy, and the law.
It is not, in principle, obvious that potential concerns about a loss of competition should significantly impede the measures needed to tackle these issues. However, as noted above, there can often be inherent tensions between commercial imperatives and environmentally responsible conduct. Below, we identify two related areas where the banking and finance sector needs to make improvements and discuss how competition concerns could arise: standard-setting and disclosures.
Increasing flows of capital are being directed to ‘ESG’ funds – those sold as having strong environmental, social and corporate governance credentials. However, terms such as ‘green’, ‘ethical’ and ‘sustainable’ are not clearly defined in the context of investing and, inevitably, fund managers and investment platforms use them in very different ways. Such ambiguity may exacerbate the problem of 'greenwashing'. For example, there are no UK regulatory standards on whether firms can feature oil and gas assets within financial products that they describe as ‘green’.
Even if there were agreed definitions, firms’ assessments of businesses and investment opportunities against these criteria are likely to differ. In the absence of well-defined terms, it can be difficult for investors to know what they are investing in, and to compare what is on offer.
By way of illustration, Credit Suisse found in one study that “there is little relationship between the ESG appraisals for a given stock by different agencies. The correlations are astonishingly low. At best, ESG ratings are a starting point, and investors need to understand them and supplement them with their own scrutiny”.
Even in the long term, it is unrealistic to expect that a sufficient number of investors will have the ability or inclination to take on such a challenging task.
A common set of minimum standards on green finance is essential. Moreover, there is likely to be merit in the finance industry coming together to agree on the definition and interpretation of terms relevant to sustainable investments and on how to assess the ESG credentials of a company. Efforts are already underway to achieve a common framework for determining which activities can be defined as environmentally sustainable, the most notable being the EU Taxonomy, and the UK Chancellor’s recent announcement that it will also implement a green taxonomy.
Potential competition concerns about standard-setting
The creation by regulators of a common taxonomy, for which activities may be considered as green, is, undoubtedly, a positive development. Nevertheless, this regulatory intervention will replace investment platforms’ and fund managers’ freedom to take an entirely independent approach to identifying whether an asset should be considered green (or ESG).
Financial markets work because investors have different expectations, and competition usually functions best when there is freedom of choice in what to supply and what to purchase. A standardised approach moves the industry away from freedom of choice over how ESG should be characterised. However, it seems likely that these independent, and differing, approaches were likely to cause confusion and risk green-washing rather than providing important freedom of choice for customers.
Even if there is agreement, through regulatory intervention, on the extent to which assets should be considered as green, the ‘social’ and ‘governance’ elements of ESG allow for broadly differing uses of the term ESG. There may be benefits in industry coming together to agree more of what these terms should mean. However, narrowing how these terms may be applied by industry-wide agreement, will by its very nature reduce an element of choice for suppliers and investors. Indeed, investors are likely to differ in the weighting they give to the different elements that may be included within ESG. Environmental factors may be paramount to one investor while social and corporate governance is crucial to another. It may be that ESG has gained popularity in part because it is open to different approaches.
In addition, more demanding standards may increase compliance costs for firms, and enhanced rigour could lead to products formerly marketed as ‘ESG’ exiting the market if they fail to meet classification requirements. In the short term, there may be a reduced choice of sustainable funds available for consumers. However, the higher quality and clarity of the retained products’ environmental credentials would point to both regulation and competition working effectively.
Demanding standards are likely to be necessary if they are to mitigate greenwashing risks. If terms like ‘green’ can apply to investments with little or no positive environmental impact, those seeking a competitive advantage by genuinely offering better sustainability credentials are at risk of being undermined.
On the other hand, some will argue that setting the bar particularly high will unfairly exclude products that have legitimate claims to being sustainable.
Setting standards will therefore likely affect competition and choosing a particular standard will not suit everyone. Indeed, concerns have already been raised in this context, as indicated in responses to a recent FCA discussion paper. These have included:
- The narrow scope of the EU’s definitions and its focus on so-called ‘dark green’ activities, which could limit sustainable investments to the exclusion of other positive-impact projects.
- The emerging definitions, with some questioning the potential inflexibility of a legislative approach, and the possibility it could stifle innovation.
There is certainly merit in some standardisation on the meaning of terms and approaches to business appraisal. Direction by regulators, and any cooperation between firms beyond this, should aim to create common standards in sustainable finance which are in the interests of consumers, so they can understand and compare the products they are offered.
The concerns outlined above remind us of the need to be careful that standardisation does not eliminate valuable competition. However, while a careful balance will be needed, it should be possible to produce standards that enable real and effective competition on environmental factors while providing better information on where to invest, and confidence that green investments are just that. Competition law-compatible standards in other areas could provide useful lessons in assessing exactly where that balance should be struck.
Information sharing and disclosure
Climate change is important when assessing the financial risks faced by financial institutions; indeed, 70% of UK banks now consider climate change to be a financial risk. However, only 10% of UK banks are taking a long-term strategic approach to managing the financial risks of climate change, and the total global and domestic value of outstanding green bonds is only a fraction of the financing required.
The UK’s Prudential Regulation Authority has described the financial risks from physical and transition risk factors as relevant to multiple business lines, sectors and geographies, meaning their full impact on the financial system may be larger than for other types of risks, and are potentially non-linear, correlated and irreversible. Arguably, this identifies climate change as a ‘material risk’ and that disclosures should be made in supervised firms’ annual reports and accounts.
In addition, the UK Government’s Green Finance Strategy sets out an expectation that by 2022 all listed companies and large asset owners should provide disclosures in line with the recommendations of the Taskforce for Climate-related Financial Disclosures (TCFD) recommendations. More recently, the Government announced its intention to make TCFD-aligned disclosures mandatory across the economy by 2025, with a significant portion in place by 2023.
The FCA has already required UK premium listed companies to include a statement in their annual financial report which sets out whether their disclosures are consistent with the TCFD recommendations, and to explain if they have not done so.
Given all this, the future is likely to see more climate-related disclosure by banks and other financial institutions. But what should such disclosure look like?
Potential competition concerns about disclosure
The TCFD identifies seven principles that effective disclosures should meet:
- Represent relevant information;
- Be specific and complete;
- Be clear, balanced, and understandable;
- Be consistent over time;
- Be comparable among companies within a sector, industry, or portfolio;
- Be reliable, verifiable and objective; and
- Be provided on a timely basis.
Detailed, transparent, comparable, and up-to-date disclosures could get competition lawyers very hot under the collar if they reveal information about competing companies that could distort competition. While it is not obvious that financial disclosures would do so, it is certainly possible. To be most useful, disclosures would provide a lot of detail on, for example: banks’ loans; asset managers’ investments; insurers’ risks; and climate change risk mitigation strategies. At what point might the revealing of such detailed information, including about future commercial strategy, lead to competition concerns?
The risk of revealing competitively sensitive information could be heightened by the different perspectives of the companies disclosing and the audiences for disclosures. For example, some investors with ESG concerns might want to know more about the climate change implications of investments, while disclosing firms may not see these as having a material impact on their business. Thus, investors or users may want more commercially sensitive information to be revealed than the business would otherwise provide.
The TCFD’s Climate Risk Financial Disclosure Guide 2020 (the Guide) highlights this risk explicitly. It gives a hypothetical example in which:
- the user of the disclosure wants information on the scenarios and assumptions adopted alongside the financial impact of climate-related issues on the business; but
- the business preparing the disclosure considers that disclosing scenario analysis assumptions is difficult due to their inclusion of confidential business information.
The Guide considers how commercially sensitive information might be revealed as a by-product of disclosure, and how this could either harm competition, or be used as an excuse not to engage in proper disclosure. Ultimately, as with standard setting for green terminology, a balance will need to be struck between providing disclosures that are sufficient to inform investment decisions, but which do not distort competition unduly.
The risks of collusion over disclosure
Might there also be a risk of collusive behaviour over financial disclosures?
The Guide states that “High-quality disclosures can be viewed as a competitive advantage for firms,” and that “Investors, regulators and consumers should… value high quality disclosure…”.
However, it recognises that, conversely, a barrier to financial institutions disclosing climate-related financial information is the potential competitive disadvantage that may arise if such disclosure reveals a firm’s position vis-à-vis its competitors.
Might firms compete over the quality of their financial disclosures, if investors value this quality? If so, is there also an incentive to collude? Businesses would have less incentive to reduce climate-change financial risk if they did not need to disclose these risks in detail; and businesses may not feel the need to do so if they think their competitors will take the same approach. There may therefore be incentives to collude (even tacitly) to reduce the detail and quality of disclosures.
We are not aware of any past instances of financial institutions colluding over the quality of disclosures; and one might not expect issues to arise specifically in relation to climate-change related financial risks. However, the possibility illustrates how the standard-setting we discussed earlier could lead to practical competition law risks. We might hope that the financial sector, particularly with a push from regulators and legislators, will introduce appropriate minimum standards of disclosure, and for these to become more demanding over time; but conversations about minimum standards risk effectively setting a maximum standard.
The banking and finance industry has a critical role in allocating capital towards more sustainable technologies. To achieve this, firms will need to work both individually and together, as well as following the lead of regulators and government.
It will be important to ensure that cooperation does not lead to competition concerns. For example, standard-setting will play a valuable role in supporting the development of an orderly and trustworthy market and reducing greenwashing. However, it could also lead to unintended consequences, such as reducing customer choice. Standards need to be designed carefully to avoid inadvertently reaching such outcomes.
Banks and other financial institutions will face increased pressure for greater transparency about how climate change risks may impact on their assets and business models. Investors may need considerable detail to make their investment decisions. Greater detail creates a risk that the information shared through disclosures, intentionally or otherwise, leads to a softening of competition, since uncertainty about the strategies and actions of one’s rivals is an essential element of effective competition. However, a lack of detail may undermine investors’ ability to assess the environmental sustainability of businesses in which they are considering investing. Disclosures will need to strike the right balance between the two considerations.
Of course, banks and financial institutions will need to consider the risks of competition law enforcement action by authorities when cooperating with competitors. However, we believe that it is possible both to increase the consistency and transparency of ESG definitions and to improve the quality of financial disclosures in this area in a way that is compatible with competition law. Competition law should not be a barrier to progress.
The greater risk may be that the actors in this industry use competition law as a reason not to act, whether to avoid setting demanding standards in how terms are defined, or to avoid disclosing how their businesses and assets affect, or would be affected by, climate change.
Ultimately, if the reality of driving sustainability objectives forward creates significant tension with competition law, government may need to decide between competing public policy goals, for example by amending competition law to take greater account of the need for sustainability.
The views expressed are those of the authors and do not necessarily represent the views of the institutions where they work.
This Insight article has been adapted from a longer article published as part of the book Competition Law, Climate Change, and Environmental Sustainability (edited by Simon Holmes, Dirk Middelschulte, and Martin Snoep), March 2021, published by Concurrences.